What's the Future of the Oil and Gas Industry?

For the oil and gas industry, 2020 was already shaping up to be one of the most challenging years in its history. Then two major events happened

The sector was facing increasing headwinds in the form of growing pressure from investors to set out their plans to deal with climate change risks. Pressure that really started to ramp up in January when the world’s biggest asset manager, Blackrock, wrote to the companies it invests in (which is almost all of them, because it is so large) telling them they needed to take more account of environmental issues including climate change.

Meanwhile the shale sector in the US has also been under growing pressure from Wall Street to show that it could make money as well as produce oil and gas. 

Then the industry was hit by two massive shocks at the same time, either one of which would have been a hammer blow on their own. 

The first is the sudden, dramatic drop in demand caused by the Covid-19 pandemic and governments’ response to it around the world, which has grounded most of the world’s aircraft, removed most cars from the roads and shut down huge swathes of industry worldwide. Then, to add insult to injury, Saudi Arabia decided to abandon its support for oil prices and increase its production.

Coronavirus has caused demand destruction on a scale we have never seen before

The effect of this has been instant and dramatic. Oil prices, which had held steady at around $60 a barrel for the past two years, have more than halved to well below $30.

This is fundamentally different from the last two oil price crashes, says Mark Lewis, head of climate change investment research at BNP Paribas Asset Management. “In those sell-offs, the oil price fell because it was so high that economies could not cope with it. In 2008-09, the price fell from a high of $147 a barrel to $35, while in 2014/15 we had a price of more than $100 a barrel for three years in a row. The price drop was just a normal readjustment of the market. This time, the coronavirus has caused demand destruction on a scale we have never seen before. It’s like a vicious punch to the stomach.”

Share prices have plummeted too, with oil giants ExxonMobil and BP, among others, seeing a slump in demand to the lowest level in 25 years. The online streaming service Netflix is now valued higher than ExxonMobil, thanks to a surge in subscribers during Covid-19 lockdowns, which have boosted its share price to a new record high of $448 (£360), taking its market value to $196bn.

Oil and gas analyst Mike Coffin, from Carbon Tracker, a research organization that highlights the risks the sector faces from climate change for more than a decade, says the shale industry, in particular, will suffer. 

Shale producers have higher costs than conventional oil producers because they need to constantly drill new wells to maintain production. Traditionally, they have used borrowed money to fund the drilling and used the proceeds of selling the oil and gas to service that debt. That worked when oil prices were $60 and above because the sector drove down its production costs during the last downturn in prices—but breakeven prices for US shale producers range between $23 and $75 a barrel, compared to Saudi Arabia’s $7 per barrel cost and Russia’s $15. “The banks and capital markets are becoming increasingly impatient. The industry is ten years old and it is still not cash flow positive (or making more money than it spends),” Lewis says.

On the other hand, the way shale oil and gas is produced means it is much more flexible than conventional wells—producers can simply stop drilling. This will undoubtedly be painful—even fatal—for many producers, but others with stronger balance sheets will snap up the assets and be ready to ramp up production when prices recover. In conventional wells, by contrast, it is much more difficult to turn off the taps and so the incentive will be to keep on producing.

The result may be that the shale sector finds it easy to cut production but may find it a lot harder to increase it in future. “We don’t see shale surviving in the long term,” Coffin says.

And when the pandemic finally recedes and we start to return to normal life, the industry will still face pressure to clean up its act in the face of the threat from climate change and other environmental threats such as plastic pollution. Oil producers have consoled themselves with the thought that at least there would still be strong demand for plastics and chemicals, but the backlash against ocean plastics has led to increased efforts to replace oil as a feedstock, using everything from plastic waste to used cooking oil from restaurants.

And all the while, demand for oil and gas is steadily being displaced by clean technologies. Surprisingly, there has traditionally been little correlation between oil prices and renewable energy investment because renewable technologies have been used to produce electricity and very little oil is used to generate power. 

But that will change. The global economy will become increasingly electrified as more electric vehicles come onto the market and heating is decarbonised. And a growing proportion of that electricity is renewable. “Electricity demand is growing 1.5 times faster than overall energy demand,” says Lewis, “and the growth rate for renewable energy is two to three times that of oil.”

Meanwhile, the price of renewable energy has fallen so much that it is now competitive with oil at $35 a barrel, which is higher than current prices. But even though this clean energy will cut demand for oil for cars and heating, it is still producing electricity that is bought on long-term contracts with stable prices, meaning that it doesn’t have the volatility that we have seen in the oil market recently and so it is a much more attractive investment. 

When times have been tough previously, the sector has always been able to retain the loyalty of investors by paying out large dividends. But even this will become increasingly difficult to do as revenues are hit by the double whammy of much-reduced prices and much lower volumes of oil and gas being sold. 

Companies will react in one of two ways, according to David Parham of the Sustainability Accounting Standards Board (SASB). “Some see themselves as primarily oil and gas companies and their strategy to remain resilient is to be the lowest cost producer by implementing very aggressive cost cutting,” he says. Many companies will focus on projects that have little technology or exploration risks, short pay-out time horizons and can take advantage of significant existing infrastructure in an attempt to take a bigger share of a shrinking pie.

“But there are other companies, such as Shell, BP and Orsted, that are aspiring to be more than oil and gas companies and increasingly diversifying their business models away from that,” he adds. Orsted (formerly Dong Energy, or Danish Oil and Natural Gas) is exiting fossil fuels entirely and is now one of the world’s biggest producers of electricity from offshore wind, while Shell and BP have both stepped up their investments into renewables and electric vehicle charging.

Indeed, BP is the most recent oil group to announce that it will be a net zero company by 2050. The company has said that it will set out more details in September, and plenty of people are sceptical at the announcement.  Alice Bell, co-director at the climate change charity Possible, wrote in the Guardian, for example, that “It’s hard not to see the rhetorical use of the “net” in net zero as a bit of smoke and mirrors, a way of making it sound as if it is taking the crisis seriously while avoiding the simple truth: we need to stop burning fossil fuels.

“If BP really wants us to believe that a company that made its name in oil can be part of the solution, it needs to stop drilling. It’s as simple as that.”

But while not everyone is convinced by the move, no-one is especially surprised BP has made—even though such a plan would have been unthinkable a couple of years ago. The announcement follows similar commitments by Shell and Spanish oil group Repsol and most oil companies have made some kind of environmental commitment. What will follow is a cycle of ever more ambitious targets as companies come to realise their opportunities to make money from oil and gas are diminishing.

With Covid-19 slashing demand and competition from renewable energy increasing competition on the supply side, the oil and gas sector is facing a perfect storm—and it seems increasingly clear that not everyone will survive.