By Paul Spedding
BP chief executive Bob Dudley is at risk of being branded an altruist if his “Oil and Money” speech to the industry this month is anything to go by.
His concern that oil prices might rise due to lack of investment is an unusual sentiment for a man running a company whose lifeblood is served by higher oil prices.
“I believe the more serious systemic risk comes from underinvestment in oil and gas exploration and production – not overinvestment,” he told the London conference.
Of course, he is correct that a reduction in investment will likely result in lower production. But BP does not have an obligation to feed the world more energy at an affordable price. Its obligation is to deliver maximum returns to its shareholders. We suspect that this apparent ‘altruistic’ policy is linked to the recovery in oil prices. There is nothing like higher oil prices to get boards thinking about raising expenditure.
The problem Carbon Tracker has with this thinking is that historically, time and again, it’s often been the wrong thing to do.
In 2007, the oil price started to rise, hitting over $100 (in today’s money) a year later. Many in the industry proclaimed this was the new normal and many revised their long-term planning assumptions for oil prices to the $70-$90 area.
This meant a surge in the number of potential development projects. Exxon is a good example. Its upstream capital expenditure rose threefold between 2007 and 2013. But despite oil prices remaining over $100, its investment returns halved. This was reflected in its share price performance – its total returns between 2008 and 2013, a period of record oil prices, were two thirds that of the S&P 500. It even managed to deliver lower returns than a peer group of similar majors. Hardly a strong endorsement of the policy of boosting capex threefold.
So we fear that the oil industry is ignoring history and considering boosting spending because of the recovery in oil prices over the past year. Dudley’s comments about a supply shortage suggest it’s a possibility. Despite Paris Agreement targets and the growth of renewables “…BP economists estimate that many trillions of dollars of investment in oil and gas will still be required to counter the substantial decline rates of existing fields,” Dudley said.
A stronger indicator is Shell’s decision to go ahead with its $40bn capital intensive Canadian LNG project. Such projects are incredibly capital hungry and traditionally low return – even if they come in on budget and on time.
So why does increasing investment often hit company and shareholder returns? The simple answer is that as investment increases, more and more high cost, low return projects come in to the portfolio. Between 2007 and 2013, Exxon’s production hardly changed. But its capital employed, a measure of the amount of cash it has invested, rose by more than two-fold. Deploying twice as much cash for the same level of production was always going to hit returns.
Of course, it might be that the oil industry is good at forecasting oil prices and so BP’s view of prices rising might vindicate increased investment. But there is little evidence of this. In November 2014, when the oil price was just coming off its $100 plus high, Bob Dudley commented “We have only sanctioned or approved projects based on an $80 oil price”.
Sadly, by end 2015, the oil price had tested $50. Those $80 projects may not have been physically stranded but we suspect they delivered lower returns than the board anticipated at the time of sanctioning. From a shareholder view, their returns could be considered well and truly “stranded” even if the assets concerned were still operating. A subtle distinction but an important one if you are interested in economic returns rather than semantics.
Mr Dudley’s resistance to disclosing scenarios covering the financial impact of price changes that could lead to “stranding” of BP’s assets seems disingenuous to us. “We could go the way of people who want to drive a wedge between the energy industry and investors – between oil and money, if you like. They push for potentially confusing disclosures,” he said.
BP already reports quite detailed financial information of its oil and gas reserves in its annual report. This includes valuations (net present valuations) of its assets on a regional basis. Presumably, this is not “confidential” and is deemed “useful” by regulators. It seems to us that it should be quite simple for BP to replicate this information for other price scenarios. And far from not being “useful”, price sensitivity is a key variable for the investment community at wide, especially in the oil sector. It would also enable investors to gauge the potential change in value that might result from an energy transition. That certainly sounds “useful” to us.
CTI has often commented that oil companies need a “Head of Memory”. It is the Head of Memory’s job to look at proposed changes to strategy and remind them how and why it went wrong last time. So, what would the Head of Memory be saying to the board today?
First, be very disciplined with your capital expenditure and don’t use higher short-term oil prices to justify an increase. The past shows such behaviour lowers return, even in a high oil price environment. BP’s first duty is to shareholders: it has no obligation to meet the world’s energy demand.
Second, when forecasting oil prices, look at all possible demand scenarios and use conservative pricing. Using a business-as-usual scenario is not conservative – it’s a best-case scenario. It’s also a low probability outcome. Make sure your business is properly resilient to an energy transition. Don’t increase your planning assumptions just because the oil price has risen over the past year — that’s what happened in 2008!
Remember that five years is a really short time in the oil industry. You can afford to wait. And in a world where demand for crude could enter a permanent decline within the next 5-10 years, do you really want to bet investor returns on oil prices remaining high?
Perhaps it might be better to wait and see. You could always invest the cash saved by buying back all that cheap stock that the divestment movement is calling on investors to sell.
Paul Spedding is a senior research advisor to Carbon Tracker; editing by Stefano Ambrogi