11 November 2019

Decarbonization and the Future of Oil and Gas Investments

By Francesco Castellano and Alessandro Innocenti 


Oil & gas companies and the concept of decarbonization do not sit easily together. ExxonMobil’s recent carbon tax controversy clues us into the fact that we still have a ways to go to figuring out proper decarbonization efforts for the oil & gas industry. However, one size cannot fit them all: some companies are firmly stuck to their core activities, others have made a complete shift towards a green business in a few years, and others again are (maybe) proceeding with small steps towards a diversification. Which strategy is the market rewarding?

This article looks at the potential financial ramifications of climate change and how oil and gas companies, in particular, can most effectively invest in their decarbonization efforts.

1. Why Do We Need to Reach Zero Emissions?

There is statistical evidence that global warming is occurring, with an average increase of 0.8 °C of land and ocean surface temperature having been recorded between 1880 and the present day. The main result of this warming effect is leading to a change in the world’s climate.

Climate change effects are evident across the natural environment. The variation of precipitation distributions, the melting of polar ice caps and behavioral shifts of many animal species being some examples of this. Humans have also been impacted, as we have seen through recent climate variability-related extremes, such as floods, droughts, heat waves, and cyclones, that are highly affecting the anthroposphere, with growing economic and societal damages.

In 2017, Munich Re estimated the economic impact of natural disasters to be $330 billion and costing more than 10,000 lost lives. The number and impact of natural catastrophes have steadily increased since 1980. The temperature anomaly trend is strongly correlated to anthropogenic emissions of greenhouse gases (CO2, CH4, N2O, F-gases).

Atmospheric Carbon Dioxide and Earth’s Surface Temperature Changes (1880 - 2018)

The unprecedented economic and demographic growth of the last 150 years is a large driver behind the rise of greenhouse gas (GHG) emissions. Nowadays, the overall annual emissions of GHG are between 49 and 52 Gt (Gigatons) of CO2,eq (carbon dioxide equivalent) per year.

Greenhouse Gas (GHG) Emissions by Type (1970 - 2010)

Under current policies, there are no clear signs that annual emissions will decrease, with their peak forecasted to be at around 2090. In one scenario, the result of this will be an increase in the average global temperature (compared to pre-industrial levels) from between 3 °C and 5.5 °C by 2100. Some of the most recent estimates arrive at up to 7°C for the "business-as-usual" scenario.

What are the consequences of a change in temperature in the earth's biosphere? Some of the phenomena with the highest probability of happening are: animal and plant extinction, food scarcity, human health problems, extreme climate variability, and ocean acidification. To prevent these events from occurring, scientists have recommended containing the earth's temperature increase to stay below 1.5 °C by 2100. A logical path towards this goal is to have a peak of GHG annual emissions within the next 10 years, and to then work towards reaching zero emissions by around 2050.

Reaching this target will require a concerted effort on the part of human society. Industrial sectors that nowadays have a fundamental impact on world economics and people's lives will have to deeply revise their paradigms in order to cut their GHG emissions to zero.

2. What Is the Impact of Individual Industrial Sectors on Climate Change?

Overall GHG emissions can be quantified and allocated into nine main sectors. Their steady growth trend has shown a strong degree of correlation to the world's total GDP. Currently, only first-world countries show a decoupling of emissions and economic growth, which is primarily being driven by improving energy efficiency measures.

Greenhouse Gas Emissions by Sector

As can be expected, the Energy sector is the most impactful one, accounting for 46% of all GHG emissions. The combustion of fossil fuels in electric power plants or for use in heating systems causes most of the sector's emissions, through the form of carbon dioxide. The availability of cheap and common energy sources has historically been a necessity for nations' economic development. To demonstrate this point, China and India have led the rising trend of energy-driven GHGs over the last twenty years, which has coincided with their industrial emergence. Balancing the need to cut emissions with promoting industrial (and economic) development is a key discussion in the climate debate, with no practicable solutions thus far.

All of the most impactful industrial sectors are bound by their reliance on the use of fossil fuels as a primary production input, be it gasoline for road transport, or coal for steel production in heavy industries. A notable exception is agriculture, which only needs a small fraction of fossil fuels and hence does not generate significant CO2 emissions. However, ammonia-based fertilizers and livestock emit  significant quantities of other greenhouse gases, and deforestation caused by the need for new fields decreases the capacity of the planet to absorb CO2.

What Is the Impact of the Oil & Gas Industry?

Fossil fuels (coal, oil and natural gas) have always been seen as the primary engine of human development. Their extraction and utilization contribute to the atmospheric release of 86% of CO2 and 25% of CH4 of total annual emissions.
The oil and natural gas subsector causes about 70% of total fossil fuel emissions. Their research, extraction and processing is controlled by over 200 companies, divided between private and national entities. Combining all of the presented data shows that the impact of these companies on GHG emissions can be estimated to be about 50% of the world's total. Within these figures, we must distinguish between the direct and indirect emissions of the Oil & Gas sector.
Indirect emissions are the consequences of fossil fuels used as direct inputs. Conversely, direct emissions caused by the Oil & Gas supply chain, deriving from production, processing and distribution to end customers.

Breakdown of direct GHG emissions by element for oil and gas

The oil supply chain emits around 3.1 Gt of CO2,eq per year, which is about 12% of the overall impact caused by the Oil & Gas sector. The refining stage is the most impactful: during crude oil processing, light gases such as CO2 are released. Also, upstream methane leakages and flaring are prominent factors, since natural gas is a by-product of the oil industry; usually being vented into the atmosphere or burned.

The gas logistics network releases about 2.1 Gt Co2,eq per year, which is 8% of the industry's total emissions. Most of the emissions come from defects in the gas distribution pipes that cause leakage of natural gas. Another important source is the actual energy needed for well drilling and extracting fuel.

To summarize, the direct emissions of the supply chain account for 20% of the Oil & Gas Industry impact. The remaining 80% is caused by combustion or from the fossil fuels' used in industrial processes.

3. How Are the Major Oil & Gas Companies Investing in Decarbonization Measures?

The decarbonization process that is expected to occur during the next 10-15 years will be mostly related to a shift toward a different energy mix. This process will be quite complex, as fossil fuels still dominate the current primary energy mix, as shown below. Natural gas and oil account for 57% of the world's total energy primary consumption.

World Consumption of Energy by Type

The present growth path of energy use appears incongruous within the context of lowering emissions, with emissions rising by 2% alone in 2018. Despite this, energy players are playing a critical role in driving the implementation of decarbonization. For this reason, it is important to understand where each company is investing its relevant resources.

Considering the overall energy sector, investments in renewables are every year becoming more relevant, surpassing $300 billion in 2018, but still lagging behind traditional fossil fuel investment categories.

2018 Global Energy Investment and Change Compared to 2017

Looking towards the future, let's focus on the most relevant global Oil & Gas companies, the ones that together represent about 25% of oil and gas produced daily and with $2.206 trillion of aggregate revenue in 2018: Shell, Total, Eni, BP, Exxon, Chevron, Sinopec and Saudi Aramco. In this way, we can get a comprehensive view on the projected investments in the Oil & Gas ecosystem across different company cultures.

BP (2018 Revenue: $304 billion)

BP was the first major player in the sector to invest in renewable energy during the 20 years of its "Beyond Petroleum" campaign. During this, it spent $10 billion on cleantech, but subsequently shut down most of the related activities after 2011, due to sensitive economic losses. In any case, BP remains the Oil & Gas company with the largest amount of renewable energy generated, due to the legacy of this campaign.

Looking at the present situation, BP plans to deploy $16 billion per year of capital expenditures, of which only $0.5 billion per year will be directed towards low-carbon technologies. In 2018, it acquired the solar power company Lightsource, but statements from BP's CEO suggest an insufficient current pace towards a realistic energy transition of the company in the short-to-mid term.

Chevron (2018 Revenue: $159 billion)

Chevron has kept a strong focus on Oil & Gas with very few investments made (its CAPEX budget was $20 billion in 2019) into renewables. As its main actions to mitigate climate change, Chevron is primarily focusing on carbon capture, biofuels, energy efficiency, reduced flaring, and fixing methane leaks.

Chevron also launched its Future Energy Fund, with an initial commitment of $100 million, to invest in breakthrough technologies that enable energy transition to lower carbon emissions, while supplying reliable and affordable energy. The fund has invested in Carbon Engineering, one of the most advanced companies in carbon capture, Chargepoint, a leading electric vehicle charging network, and Natron Energy, a new generation of sodium-ion battery products.

Eni (2018 Revenue: $85 billion)

Italy's Eni recently announced a decarbonization strategy. Its plan centers around specific actions to reduce impact, along the lines of increased efficiency, forest conservation and growing its share of zero carbon sources. Eni currently has 0.2 GW in installed renewables capacity globally, with a goal of reaching 5 GW by 2025.

4% of Eni's 2019-22 CAPEX budget of $9 billion is allocated to renewables. On the R&D side, Eni has invested $83 million in decarbonization solutions, like renewables, green chemistry, energy efficiency and emission reduction.

ExxonMobil (2018 Revenue: $290 billion)

Like most non-European players, ExxonMobil has made relatively less  investments in sustainability projects. Its projected $1 billion per year spend in alternative energies mostly goes into advanced biofuels and carbon capture R&D, but it is yet to make any acquisitions - nor major investments - in cleantech thus far.

However, ExxonMobil is planning to power its Texan oil production plants with 500 MW of solar and wind energy, which while small relative to its entire operational base, does show positive steps forward. Fossil fuels and chemicals continue to be core sectors for the firm; it plans to invest $32 billion into these areas over 2019-2020, via several major projects.

Saudi Aramco (2018 Revenue: $356 billion)

This Saudi Arabian state-owned conglomerate is the most profitable company in the world. Its disclosures are not as comprehensive as other firms, so it is not exactly clear where its $40 billion of annual CAPEX over the next decade will be directed. However, its strategic plan and acquisition/investment patterns point toward a focus on core oil business concerns.

Renewable power generation has not been a core focus of Saudi Aramco, and its efforts on reducing emissions appears to be heading more towards energy efficiency and carbon capture. For its forthcoming IPO, with a valuation that could reach $2 trillion,  the company is strongly relying on its oil market position. This concentration poses a strategic risk, as shown after a September 2019 drone attack on a major oil processing facility that halved its production, leading to reports of a delay of its IPO.

Shell (2018 Revenue: $388 billion)

Shell is the largest European player in the oil and gas sector. Its oil reserves have been decreasing since 2013, and now are well below the industry minimum standard of 10 years. Moreover, looking at the structure of its projected capital expenditures of $30.5 billion per year from 2021-2025, its main objective appears to be sustaining existing infrastructure, with only $1.5 billion per year invested in growing oil reserves.

Instead, Shell is focusing $2.5 billion per year in developing its new Power sector, with the aim of becoming the largest power company by 2030. Its internal VC fund has invested in around 20 cleantech or alternative energy companies over the past 5 years, and it has recently acquired relevant startups in the field of energy storage and EV charging.

For all these reasons, Shell seems to be following a more "low-carbon" path for its business, with a slow transition towards becoming a broader energy utility. However, it is not forecasting major divestments in its upstream sector, in particular in the gas sector, where it plans to spend $2 billion per year to increase reserves.

Sinopec (2018 Revenue: $415 billion)

Sinopec is the largest nationalized Chinese Oil & Gas enterprise. Despite statements about its commitment to sustainable projects - i.e. geothermal heating and a $1.5 billion fund for new energy - there are no exact figures on how it invests annually in cleantech. Looking at its CAPEX structure for 2019, it planned to invest $8.4 billion in upstream and $10.3 billion in downstream operations, with only $0.5 billion directed to generic R&D. Sinopec clearly classes natural gas as "clean energy", and forecasts to expand within the sector. Indeed, recent capital expenditure forecasts have focused on the upstream exploration of shale gas.

Total (2018 Revenue: $230 billion)

Total has integrated climate change into its strategy, with the aim of accelerating its transition to decarbonization. Total invests $18 billion of CAPEX per year, with $4 billion allocated into renewables over the period 2020-2025, towards a goal of reaching a capacity of more than 25 GW by 2025. Alongside initiatives in carbon neutrality and forest generation, Total also uses its venture capital unit to invest in various projects related to clean tech, ranging from mobility to energy generation.

Disclosed Future CAPEX Spend Projections by Major Global Energy Companies, 2019 -

4. What Needs to Be Invested to Meet the Intergovernmental Panel on Climate Change  (IPCC) Targets?

Taking stock of this analysis, over the coming years, the top oil and gas companies altogether plan to spend around 4% of their total budget on cleantech. Is this enough for the emission reduction targets? And will retaining a high expenditure on Oil & Gas still be appropriate within the context of a lower emissions narrative?

In 2018, IEA estimated that for a change in the energy mix that is compatible with a 2°C maximum temperature increase by 2100, the world should invest $13.8 trillion in renewables by 2040. Such a scenario would necessitate an average spend increase of $230 billion each year, when compared to the current budget trends.

Moreover, across the same period, expenditures on fossil fuels should decrease by an average of $380 billion per year to reduce the impact caused by oil, gas, and coal. It can be assumed that for the conservative 1.5°C increase scenario this reduction would need to be even higher.

Of course, Oil & Gas companies cannot be the only protagonists leading these investments and divestments. There is a need for a holistic approach across the entire energy sector to address this situation. Nevertheless, it is undeniable how some of these companies appear to have delayed steps towards the projected trend of decarbonization, despite having the spending power that could drastically change the shape of the energy market.  Planned increases of oil production (an average +8% in 2030, when compared to 2018) and significant lobbying spend countering green policies are further indicators suggesting that the Oil & Gas sector is not yet onboard with the decarbonization process.

Positive Actions Already Shown by Oil & Gas Companies

There are positive cases of companies that are successfully embracing an energy transition path. DONG, the Danish state-owned operator, modified its name in 2017, becoming Ørsted. This was the outcome of a progressive change in its core business that began a decade ago, bringing about the complete divestment of its oil and gas activities, which were sold to INEOS in 2017. Ørsted is now the biggest player in the European offshore wind energy market, with a 16% share and 3,000 MW of installed capacity, of which 450 MW were installed in 2018 alone. It aims to be completely carbon-neutral by 2023, when it will have sold its last coal-based power plant. With $9-11 billion of annual revenues over recent years, Ørsted is small in comparison to the companies analyzed in this report, and the smoothness of its transition into a new market can be explained by its reduced scale.

Another positive example is from ENGIE, a much larger player with $68 billion of revenue in 2018. ENGIE started its deep energy transition in 2016, after the collapse of oil and gas prices during 2014-2015. It sold its exploration and production unit for $3.9 billion to Neptune Energy in 2017, and is now progressively divesting coal power plants and increasing the efficiency of its natural gas operations, with innovative projects such as the introduction of hydrogen into the gas distribution grid. ENGIE plans to install 9 GW of renewable power by 2021, with $11-12 billion of CAPEX budget allocated to assist. The acquisitions of solar power utility Solairedirect and microgrid company EPS further demonstrate its intent. ENGIE has seen its strategy impact upon revenue, in 2018 it recorded growth of just 1.7%, compared to double-digit growth from all of the major Oil & Gas companies.

ENGIE and Ørsted show examples of how to achieve a complete energy transition. Both are progressively divesting away from fossil fuels over a 10-15 year timespan. The obtained cash flow is being used to build new portfolios, mostly in renewable power plants, energy storage systems, and smart grids.

5. What Can We Expect in the Future?

Investors are beginning to look more favorably at cases like those of Engie and Ørsted, with long-term vision gaining more prominence over short-term profits in the energy sector. Environmental, social and governance (ESG) parameters are also gaining a much higher weight of importance when evaluating investments. The growing volatility of Oil & Gas company performance, caused by fluctuating commodity prices and the jeopardy of stricter emissions regulations will impact more and moreover the decisions of fund managers.

In recent years, the overall performance of renewable power companies - in particular by smart grid operators - has been better than the top Oil & Gas players. For the latter, there is a remarkable increase of the cost of equity after the 2014 shock of fossil fuel prices, which now holds at around 12%. Conversely, renewable firms are seeing equity costs at levels lower than 6%, with a decreasing trend favored by supportive policies and higher technology maturity. Even if the profitability of these power companies is usually lower, the evident volatility of Oil & Gas ROIC and the lower cost of capital of renewables promises better outlooks for the innovative energy utilities.

Diversification is the Way Forward

Oil & Gas companies should favorably look to at least a diversification of their business towards becoming broader energy utilities, if not a complete transition towards renewable power generation for those smaller players. The recent signals that come from national governments strengthen this reasoning, as the case of the $1 trillion Norwegian sovereign fund that divested $7.5 billion from small oil exploration and production companies.

To sum up, it is difficult to get concrete answers on the future of Oil & Gas companies, due to the inherent complexity of the energy sector and its changing geopolitical conditions. Among the companies analyzed in this article, Shell and Total seem to be at the most advanced stages towards putting significant resources towards a partial shift of their core business away from fossil fuels.

In these uncertain conditions, I strongly believe that we have, at the moment, a strong technological and economical opportunity to shift toward clean energy sources. Everything will depend upon the ability to quickly move enough capital towards renewable and clean energy, while at the same time, reducing (or better, eliminating) investments in fossil fuels. At the current rate, the process is happening, but not fast enough to really produce the expected results. I believe that the companies that will lead this process will have better financial performance in the long term, relative to those that don't take the leap.