Oil and gas companies must use the current cash flow windfall opportunity to speed up decarbonisation of their businesses, Wood Mackenzie highlights in its latest report.
Stakeholders are demanding greater accountability for carbon emissions along the value chain. Net-zero Scope 1 and 2 emissions by 2050 are now the industry standard.
Focus on Scope 3 emission reductions is coming – and will carry significant implications for corporate strategies and capital allocation.
Tom Ellacott, Senior Vice President, Corporate Research at Wood Mackenzie, said: “It is incredibly rare for an industry to get a decades-long notice that its business is under threat.”
“Not only does the oil and gas industry have the luxury of clear warning, it has significant cash flow coming its way from higher prices.”
“The commodity price upcycle provides a golden opportunity to accelerate emissions reduction, with a clear financial framework,” he said.
Wood Mackenzie’s new report, CO2mmit and CO2llaborate: Squaring the carbon circle for oil and gas, argues that with current prices leading to record free cash flow, the industry should seize the moment.
David Clark, Vice President, Corporate Research at Wood Mackenzie, said: “The sector has the chance to ‘do it all’ – return cash to shareholders, fortify balance sheets and accelerate corporate transformation.”
“Many oil and gas companies willingly accept hedging costs in order to de-risk near-term cash flows. It’s time to hedge longer-term carbon risk with rising low-carbon investment.”
Clark said that to build credibility, companies should lay out a clear financial framework for their energy transition. It should cover capital allocation between dividends, financing and investment in the legacy oil and gas businesses and low-carbon businesses.
“Frameworks will vary by company, circumstances and Scope 3 business model, but they should all have one thing in common: a quantified, credible, material and rising capital allocation to decarbonisation and low-carbon solutions,” he said.
Ellacott said qualifying low-carbon solutions would include investments in new low-carbon assets or technology that help decarbonise existing assets.
But what is credible and material? The Wood Mackenzie Corporate Service estimates that the Majors will allocate around 15 per cent of their 2021 investment budget to renewables (US$15 billion, split evenly between mergers and acquisitions and organic capital expenditure).
Ellacott said: “That’s a start, but clearly too little to move the needle – and other IOCs are barely scratching the surface on decarbonisation spending.”
He added: “The 45 IOCs Wood Mackenzie Corporate Service tracks will generate a US$1 trillion cash windfall above planning and base cash flows if current prices, in a US$50-US$70/bbl (Brent) band, are sustained to 2030.”
“Allocating 30 per cent of operating cash flow to shareholders would boost collective distributions by more than 80 per cent versus 2020. That still leaves room to expand capital budgets by one-third relative to current planning and our base case.”
“If the ‘windfall’ capex is channelled 2:1 into low-carbon spending versus oil and gas, IOCs could have US$660 billion of decarbonisation investment firepower this decade, a near threefold increase.”
“This level of investment from the sector would fund more than 10 per cent of global low-carbon energy investment by 2030, compared with less than 2 per cent today. A commitment of this magnitude could be transformative.”
Clark noted: “Despite growing decarbonisation pressure from shareholders and governments, the market has continued to apply a premium rating to companies with strategies focused on oil and gas. As the climate-related risk ratchets up, this is simply not sustainable.”
“Financial institutions’ understanding of climate risk is evolving rapidly and risk-adjusted valuations of oil and gas companies will evolve with it.”
While increasing investment in decarbonisation is a necessary step, broader and more creative collaboration across industry and with government and customers is also needed.
Collaboration is the de-risking linchpin. So much of what needs to be done is industry- or economy-wide, so many sector initiatives would benefit from scale. Successful decarbonisation would help the whole industry and preserve greater asset value.
Ellacott said stakeholders need to recognise the dilemma facing oil and gas companies. He added that rapid and large-scale divestment to reduce Scope 3 emissions is counterproductive folly.
“Scope 3 reductions are fundamentally a shared responsibility between suppliers, governments and consumers. For the industry to defend that position, however, it needs to produce a credible alternative.”
“A disunited, dismissive industry runs the risk of an accelerated wind-down and derating long before oil and gas demand disappears. A committed and collaborative response, in contrast, could transform IOCs into a credible part of the solution,” Ellacott concluded.