Will the Energy Sector Evolve or Devolve?

22 February 2021
3 min read

Change in the White House has brought swift transformation to US environmental policies, especially those affecting the oil and gas sector. We don’t believe the beginning of the end is here for the oil and gas industry, but the energy sector faces substantial change—and companies need to adapt over time.

Climate Is Changing the Energy Sector

The Paris Agreement, which limits emissions to keep global temperatures within 2°C of preindustrial levels, has caused companies globally to focus on their environmental impact. Energy firms are no exception. Many management teams have been investing, planning and articulating steps they’re taking to ensure they will comply.

The European integrated exploration and production (E&P) companies are leading the charge in their commitment to emissions reduction and diversification into renewable energy. They’re able to lead not only because Europe is, on the whole, further ahead in planning and preparing for climate change, but also because they have the funding.

Oil and gas producers faced a challenging 2020 market environment. The pandemic crippled demand just as competition between Saudi Arabia and Russia created a temporary supply glut, cratering oil prices. This reinforced the conservative capital investment of E&P companies and slowed business for oil-service companies.

We are not convinced that oil demand will recover to pre-COVID levels, but the near-term outlook for oil prices is constructive, particularly if supply comes back more slowly than demand. Even though we expect capital expenditure to shift toward renewables as companies reduce carbon exposure in their portfolios, fossil fuels will still play a material role in the energy mix for decades to come.

Shorter Term, Company Impacts Will Differ

For now, though, the global economy is tentatively on the mend and producers are showing supply restraint. This should lead to a more constructive outlook for energy, albeit to varying degrees.

Investment-grade E&P companies, for example, had already been repairing their balance sheets, reducing operating expenses and preserving liquidity. For these companies, higher oil prices should lead to stronger cash flow and reduce concerns about the risk of credit ratings downgrades.

Even recent fallen angels—former investment-grade issuers that slipped into high yield due to COVID-induced financial pressures—have been bolstering their balance sheets and cash flows. Many have streamlined operations and divested assets to reduce debt faster. We expect ratings agencies to eventually notice. And we see less risk of slippage into high yield for those companies still rated BBB.

The recovery for oilfield services companies will take longer. Their US shale clients, for example, are investing to sustain production rather than grow it, and we expect them to spend 30% to 40% less than before the pandemic. Internationally, even though the Organization of the Petroleum Exporting Countries and Russia are once again increasing their activity and attempting to regain market share, we expect spending to remain 5% to 10% below 2019 levels.

Survival of the Greenest

As the world combats climate change and moves toward a carbon-neutral footprint, the energy sector is adapting, though in different ways and at different paces. Tougher emission standards are coming, and new drilling leases on federal land will be difficult—if not impossible—to obtain.

Fortunately, E&P firms extended their backlog of drilling permits ahead of the election, given Biden’s energy platform. And the slowdown in drilling activity in 2020 because of lower oil prices effectively extended the drilling life of existing permits. Plus, oil-price volatility has encouraged companies to become more fiscally conservative in recent years. As a result, smart management teams have been fortifying balance sheets and bolstering liquidity.

Some companies are adjusting their business models by leveraging intellectual property and technology. For example, as experts in energy production, some of the larger oilfield services companies are in the sweet spot to help reduce greenhouse gases. Smaller firms in oilfield services, on the other hand, may not be able to pivot their businesses.

We don’t believe that this is the beginning of the end for the oil and gas industry—the transition to declining oil demand isn’t here yet. But peak oil might be closer than we thought, as the push for carbon reduction and renewable energy sources continues. Most companies will control what they can and live through the pain of what they can’t.

Balance-sheet constraints and previous choices may leave some companies unable to change. Others can change—and will. To understand the distinction, investors need to look carefully at changes to business models and balance sheets as valuations and expectations evolve. Active engagement is a linchpin of these assessments and also a forum to advocate for best practices.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams. Views are subject to revision over time.

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