As companies in the energy and natural resource sector struggle to find the balance between satisfying shareholder returns and meeting stakeholder low-carbon demands, new strategies are emerging that could serve as catalysts to drive capital allocation decisions toward growth as well as close valuation gaps, says the research team at Wood Mackenzie.
While noting that in the last year, energy security exceeded sustainability, Tom Ellacott, senior vice president, corporate research also believes that companies equally are gaining from the commodity prices and margins while delivering the needed record cash flow.
“In the last year, energy security has trumped sustainability, and companies too have benefitted from the recent commodity prices and margins to deliver record cash flows”, Ellacott said.
However, and like James Whiteside, head of corporate metals and mining said, firms may also face the capital allocation dilemma of high hydrocarbon returns vis-a-vis lower risk, lower-return transition-enabling projects for years while also urging that they develop robust strategies to overcome the regulatory hurdles of the ongoing energy transition now at the doorsteps of countries and companies.
“The evolution of policy is a big unknown. Companies may face the capital allocation dilemma of high hydrocarbon returns versus lower-risk, lower-return transition-enabling projects for decades yet”, James said.
He added: “Rather than chasing carrots or ducking sticks, companies need to develop robust strategies to navigate the unfolding regulatory landscape of the energy transition. The metals most exposed to the transition, such as lithium and rare earth elements, have garnered more media attention than established commodities such as nickel, copper and aluminium. But it is these base metals that need to mobilize the most growth capital to achieve climate goals.”
However, three key strategies available to companies to address what now seems to look like a complex dynamic according to the report include, nurturing legacy cash cows while simultaneously shifting to a transition-growth mindset and secondly, incorporating transition risks and rewards into differentiated investment hurdles rates, and last but not the least, using new business models to enable growth and close valuation discounts.
Under the first key strategy according to Wood’s team, investors would expect companies to balance the need for returns in the short term by tending to their legacy portfolio, while delivering low carbon transformation plans. Noting that visibility of low-carbon profit centres starting to support – and supplant – the legacy cash cows could be a revaluation trigger to shift the market to a transition growth mindset, while the companies in turn scale back share buybacks to fund the shift. Adding that in 2022, mining majors and international oil companies allocated US$157 billion, (approximately) 30% of their operating cash flow, to buybacks, stating that companies could still grow base dividends and lift reinvestment rates to over 60%.
James said: “That is not to say that decarbonisations goals cannot be met and priorities cannot change. But to spur activity, there needs to be a recalibration of current risks and rewards for investment in low carbon technologies, as well as new incentives from both government stakeholders and financial institutions. There’s no one answer, but smart oil and gas and natural resources companies will realize that protecting the status quo would be a mistake and start to manage their portfolios to reflect a balanced approach of managing legacy output and carbon management.”
While noting that the only way to change investor sentiment is to bring about further shifts in the risk-reward equation, Tom Ellacott averred that expected reinvestment rates, that is, investment as a percentage of operating cash flow in oil and gas companies and miners of between 40% and 50% trail the investment rates of utilities chasing growth. Adding that reinvestment rates in both sectors have been trending down since the middle of the last decade.
Stating that even investment as a percentage of operating cash flow has, in a large part, been due to strategies such as capital restraint and massive buybacks that have been successful for companies and investors. He added that the oil and gas and metals and mining sectors have outperformed the broader market by 44% and 16%, respectively, since the end of 2021.
Says Ellacott: “Realistically, the only way to change investor sentiment is to bring about further shifts in the risk-reward equation.”
“We will have to see this in a variety of ways. Examples are government support schemes like the Inflation Reduction Act in the US, regulations such as The European Carbon Border Adjustment Mechanism, or customer-driven market creation, such as a willingness from consumers to pay premiums for low-carbon energy. Financial institutions could also play a big part by punishing slow-to-change companies with higher borrowing rates. This will all hopefully drive new investment inflection points that will catalyze more activity for low-carbon energies.”
About managing investment inflection points, the report showed that wind and solar have passed through inflection points and were scaling rapidly, resulting from strong infusions of capital, with hope alive that such similar point could also be reached for the energy transition support system – metals, CCUS, bioenergy, hydrogen and charging infrastructure.
While pointing out the critical importance of mergers and acquisitions (M&A) as well as new business models as growth enablers and guard against gaps in valuation discounts, the team in the report said that major oil companies were already using M&A to accelerate expansion into low-carbon businesses, such as biofuels, biogas and renewable power. Adding however that the overall capital allocated to low-carbon M&A has remained limited, as mining majors continue to take a low-risk approach to acquisitions of transition-focused commodities. Stating that new or modified business models could help reduce the transition valuation discount and support efficient capital allocation in businesses with quite different costs of capital and risk-reward profiles.
Ellacott said: “A transition growth mindset does not mean abandoning capital discipline if combined with risk-adjusted and transparent hurdle rates.”
“There are different horses for different courses, depending on a company’s scale, portfolio make-up, geographical focus and legacy skillset. The prize is worth fighting for, bending the carbon curve to limit the world’s temperatures to well below 2 °C. And a balanced, disciplined, transition-focused investment approach could grow corporate cash flows sustainably, boosting company valuations.”