HORIZONS

Swimming upstream:

a survivor's guide

May 2021

Fraser McKay Vice President, Head of Upstream Analysis Angus Rodger Research Director, Asia Pacific Greig Aitken Director, M&A Research

Contents

Navigating oil and gas in a time of hyper-uncertainty Extreme planning, the upstream edition Capital allocation: an upstream investment playbook Against the tide: finding a buoyant business model Conclusion: cash cows can swim

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Executive Summary

Navigating oil and gas in a time of hyper-uncertainty

Down the decades, the risks of the oil and gas industry have always been tempered by an unwavering assumption that demand would rise indefinitely. Now, however, as the energy transition gathers momentum and the upstream industry is forced to navigate uncharted waters, that belief has all but evaporated. The upstream industry now finds itself having to supply oil and gas to a world in which future demand – and price – are highly uncertain. The range of possible outcomes is dizzying. A gradual energy transition, for instance, could require the industry to invest in new production capacity for another decade or two. Wood Mackenzie’s accelerated energy transition (AET-2) scenario, in contrast, in which global warming is limited to 2 °C, sees oil demand and prices slide while gas fares comparatively well. This makes strategic planning infinitely more complicated. This Horizon examines the key issues management and investors need to consider as the upstream sector positions itself for the challenges ahead.

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Extreme planning, the upstream edition

As we saw in the April edition of Horizons, our AET-2 scenario frames the extreme uncertainties faced by the oil and gas industry as it plans for the future. AET-2 is a scenario, not a forecast, but it shows how stepped-up efforts to tackle climate change could mean a radically different future for oil and gas demand and prices, to one of continued growth.

Continued demand growth for another decade

AET-2 scenario

Figure 1: A wide range of demand uncertainties

Source: Wood Mackenzie Energy Transition Service

The current is strong and the stakes are high

The oil and gas industry has enjoyed a century of near continuous demand growth. Oil and gas demand, rebounding as the world recovers from the Covid-19 pandemic, is set go beyond the record 160 million barrels of oil equivalent per day (boed) reached in 2019. The world will still need oil and gas supply for decades to come, even as the energy transition erodes fossil fuels’ share of energy. After six years of weaker prices, upstream is fitter and leaner than ever. It will generate as much cash flow this year at US$60/bbl as it did at US$100/bbl prior to the 2014 price crash - and there’s huge value yet to be extracted. The global upstream sector is worth US$4.8 trillion based on our Lens upstream valuation models, using a long-term corporate planning price of US$50/bbl. To say operators’ valuations are sensitive would be an understatement. The range of valuations is a staggering US$3.3 trillion to US$8.7 trillion, assuming AET-2 or another decade of continued demand growth as boundaries. Total sector economic rent varies from US$9 trillion to US$23 trillion if host governments’ direct share through taxes and royalties is included. Oil and gas companies have no control over the vagaries of demand and price. But the decisions they make as the transition unfolds will be critical to maximising the value of the upstream business, however things play out.

Figure 2: Global post-tax asset valuation sensitivity

Source: Global Lens upstream, commercial asset post-tax NPV10

Figure 3: Global post-tax cash-flow sensitivity

Source: Global Lens upstream, commercial asset models

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Capital allocation: an upstream investment playbook

Upstream investment has never been for the fainthearted. Projects can take decades from cradle to grave and go through multiple commodity cycles. The energy transition brings a new level of uncertainty. How can the industry deliver the requisite supply and stay profitable, investible, resilient and sustainable? Delivery and discipline are paramount in all aspects of the upstream value chain as the macro environment for oil and gas gets tougher. Performance against budgets and timelines has improved dramatically since the last downturn, but the industry needs to remain relentless in its push to improve efficiency, drive down costs and deliver projects flawlessly. Mistakes could be disastrous. Oil and gas companies need to send a strong signal to stakeholders that they can be reliable stewards of capital. There are five key things that will influence upstream capital allocation.

1. Short-termism will reign Projects with shorter payback periods will be prioritised and portfolios with multiple and varied investment options will be of higher worth. Capturing the upside used to be a core part of the upstream investment philosophy. The future will be about minimising unproductive capital and changing tack quickly to mitigate risks. The industry’s affinity for complex, long-life developments with thin margins has to end, as does its propensity for exuberant spending when prices rise, as they are even less likely to remain up in future. Too often in the past, peak spending has coincided with peak service costs, and peak production with price nadirs. The phasing and the rightsizing of projects can help, reducing capital intensity and capturing average costs and prices throughout cycles. This approach would have generated returns 3–4% higher during the last two price cycles. Incremental onshore global conventional and North American unconventional resources are at the sharp end of short-cycle investments. Under our AET-2 scenario, very little long-term greenfield spending is required to meet demand. It is no surprise that the sliver of investment that survives is concentrated in sustaining existing production and the best available opportunities in the Lower 48. Only exceptional, low-cost projects in more challenging resource themes will work in all scenarios.

Figure 4: New project returns by resource theme at corporate planning prices

Source: Wood Mackenzie Lens upstream All averages are weighted by capital spending. Economics are based on assumed corporate planning prices of US$50/bbl Brent long term.

2. Gas is good Lower full-cycle emissions and the potential to combine with CCS/CCUS underpins the resilience of gas demand. Upstream capital should flow in that direction. It’s not happening yet – absolute spending on oil considerably exceeds that on gas. The returns on developing a barrel of oil today are higher, with oil-production and cash-flow profiles delivering more value upfront. Gas prices are lower than oil prices on an energy-equivalent basis – though in time, this relationship will reverse. Sanctioning large-scale gas and liquified natural gas (LNG) projects is already a big economic and psychological hurdle for many boards. Big gas projects can throw off huge cash flows at high margins once developed, but there is no hiding from their long payback periods and chunky capital commitments. Returns have been low and project execution hard-fought. The stronger outlook for gas demand as a transition fuel supports a pivot to gas, but the industry must find a way to generate acceptable returns from big gas projects. There are far more stalled and stranded gas than oil fields globally, simply because they are harder to commercialise. Of the 900 billion boe of non-commercial resources in our Lens dataset, two-thirds are gas. A more creative mindset is required and some of the answers come from the oil playbook. The industry is increasingly targeting smaller-scale, shorter-cycle onshore gas projects to improve optionality. But recent Eastern Mediterranean deepwater gas developments have shown that gas returns can be substantially improved through quicker and phased development, if the rocks are good enough.

Figure 5: Oil versus gas investment split

Source: Wood Mackenzie Lens upstream

Figure 6: Returns sensitivity to demand outcomes

Source: Wood Mackenzie Lens upstream, global future projects excluding US Lower 48

3. Decarbonising upstream is crucial Projects with lower carbon footprints are increasingly attractive, as are investments that decarbonise existing assets. They prolong asset lives, maintain investability and could capture price premia. The industry needs to shake off the perception that decarbonisation is a cost centre. Carbon pricing will expedite this, but most low-hanging fruit – improved facility efficiency, reduced leakage and flaring – can be value-accretive. For large companies with long-life portfolios, the next step is to think beyond Scope 1 and 2, even if they are sceptical on the pace of transition. One option would be to add more gas to the portfolio, regardless of lower baseline returns. Another would be to scale up carbon capture, both utilisation and storage (CCUS/CCS) – a great opportunity for the industry to leverage its technical expertise and infrastructure and become part of the solution, rather than part of the problem. CCUS/CCS capacity must rise from the paltry 40 million tonnes per annum today to 4–8 billion tonnes per annum by 2050 if the world is to achieve its net-zero carbon ambitions. This is a huge growth opportunity, and oil and gas companies are in prime position to capitalise. But CCUS/CCS requires coordinated progress on carbon pricing and other value streams, legislation and investment incentives. Mature infrastructure-rich basins with depleted reservoirs and saline aquifers, such as the North Sea, US Gulf of Mexico or Western Australia, are well placed to become testbeds.

4. Exploration isn’t dead It’s still a capital allocation option. Exploration budgets may be smaller and practised by fewer companies, but high-quality, low-cost discoveries can outcompete higher-cost, more carbon-intensive discovered resources. This means more focused exploration than in the past and, by extension, probably fewer exploration wells. If international oil companies continue to step away, national oil companies will become the lifeblood of the sector.

5. Competition with renewables is intensifying The largest players will increasingly measure exploration and production investment against solar, wind and other low-carbon investments. Expected returns from oil and gas projects will eclipse those of more predictable renewables for some time, but the relative value proposition will narrow over time.

Figure 7: Competition for capital

Source: Wood Mackenzie Lens upstream at US$50/bbl Brent long-term *A blend of large IOC/Majors’ internal hurdle rates.

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Against the tide: finding a buoyant business model

Upstream oil and gas business models will change as the transition gathers pace. Companies will need to follow the blueprints for best-in-class capital allocation and prioritise the stability and dependability of dividends over growth. ESG considerations will increasingly determine capital availability.

1. Serial consolidation is inevitable as peak demand nears The pros? Reduced overheads and less competition plus increased efficiency and buying power equals higher margins. The cons? Less innovation, an inability to attract and retain talent and the decision-making inertia that comes with bigger companies. Consolidation is already well underway in the highly fragmented US Lower 48 and is more advanced in the Canadian oil sands and other mature markets. The trend will widen and accelerate and could include a new wave of mega-mergers.

Figure 8: The need for consolidation

Source: Wood Mackenzie Lens

2. Specialists will fill any gaps Some specialist companies could become very large. The niches they will exploit will be based on existing technical and organisational competencies. Examples include mature asset rejuvenation; low-cost vertically integrated specialists in harvesting and retiring assets; leveraging close ties with host governments or regional integration with demand centres. For some, the competitive advantage could be ownership by entities that are freer of ESG constraints than mainstream investors. Conversely, for others, it could be a specialism in maximising valuation multiples through improved ESG performance.

3. Spinouts and joint ventures will be created, as uncertainty drives corporate restructuring At the Majors’ level, Big Energy could split into ‘GoodCo’ and ‘BadCo’ along the boundary of new and old energies. Investors could choose between the two to suit their growth or dividend strategies. GoodCo – new energies – would need to be of sufficient scale for this to be meaningful. Some are already considering separate entities for new energies businesses to test the concept, attract lower-cost capital and win higher valuations. On its own, however, this does not address the issue of how to effectively manage the upstream business. There are, of course, more dramatic options. Fit-for-purpose investment vehicles could be created using joint ventures or innovative deal-making to align interests across regions or resource themes. A solution for large international oil companies trying to exit non-core areas to improve investment discipline could be to aggregate portfolios in areas such as West Africa or Asia. The new entity would create efficiencies and improve margins. Cash flow would be distributed, but remain at arm’s length of the core upstream operations of Big Energy. Could new, very large-scale integrated gas companies solve the investment conundrum by creating the right mix of short-cycle piped gas, offsetting the risk of developing LNG megaprojects?

4. The rise of resource-holding national oil companies The biggest national oil producers (NOCs) will gain market share in all demand scenarios. Middle Eastern NOCs have the lowest-cost, lowest-carbon barrels and cheap finance, making them more resilient to change than their international brethren. But any cash-rich NOCs will view uncertainty as an opportunity to acquire assets in a buyers’ market. While they will retain the appetite to develop big projects, they will have to future-proof them too. As the rapid emergence of ‘green LNG’ proves, disruptive change can come fast. Qatar is already the lowest-cost supplier of LNG, but its decision to invest in CCS/CCUS means it can offer low-carbon molecules as well, effectively locking in its competitive advantage. Other national oil companies are looking to repurpose old fields and infrastructure for CCS/CCUS, hydrogen and renewables, and many have the capital to scale it up.

Heatmap of global upstream emissions (Scope 1 and 2)

Source: Wood Mackenzie Lens

Cost of capital and ESG Inevitably, the cost of capital and the cost of doing business in oil and gas will increase. We’ve seen it in coal, where the shift to smaller niche financiers increased thermal coal’s funding costs. The availability of capital is not the issue; instead, coal projects fail due to their economics, payback periods or lack of regulatory approval. Despite having a less challenging future than coal in almost all energy transition scenarios, the same will be true for oil and gas. Viable projects will get funded. Stakeholders from banks to insurers are considering whether oil and gas still fit with corporate mandates. Direct ESG risks, such as carbon pricing, demand destruction, social licences and other factors, are used to screen investments. An ever-increasing proportion of blue-chip investor capital will disappear. The onus is on oil and gas companies to improve their ESG credentials. The bond of trust with stakeholders, which grants them a licence to operate, must improve. For the biggest players, diversification into new energies will play an increasing role, but this is a not an option for many industry participants. They will need to reduce Scope 1 and 2 emissions to reduce their exposure to increasingly expensive debt. Talent and technology Navigating the energy transition puts people and technology in the spotlight as never before. Technology promises efficiency from leveraging data with artificial intelligence and super-computing. The brain-drain of technical expertise into growth sectors, including the low-carbon value chain, is already a concern. Upstream has always had a highly skilled and dedicated workforce. The industry needs to continue to compete for best-in-class talent. This includes engineers and geoscientists but, increasingly, a more diverse pool of data science, technological innovation and other skills are required. To attract them, the industry needs to position itself as a high-tech, sustainable business with its own leading-edge technologies, such as CCS/CCUS, in which new recruits and existing employees can build a satisfying career.

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Conclusion: cash cows can swim

Oil and gas is a risky business. Over the years, those risks have been tempered by a single tenet – that oil and gas demand would continue to rise indefinitely. As the energy transition gathers momentum, however, that belief has all but evaporated. The upstream industry now finds itself having to supply oil and gas to a world in which future demand – and price – are highly uncertain. The range of possible outcomes is dizzying. A gradual energy transition, for instance, could require the industry to invest in new production capacity for another decade or two. Wood Mackenzie’s AET-2 scenario, in contrast, sees oil demand and prices slide while gas fares comparatively well. Strategic planning gets infinitely more complicated when the possibilities of a two-degree world are incorporated. We believe management - and investors - need to bear in mind four key things as the upstream sector positions itself for the challenges ahead.

As the upstream sector tries to navigate these uncharted waters, financial strength will be its life jacket. Even under our AET-2 scenario, upstream is a cash cow; a few more years of firm prices would strengthen balance sheets, making a choppy voyage more comfortable. Whatever happens, upstream will remain big business and provide enormous support to the global economy for quite some time to come.

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