Introduction
Oil and natural gas (O&G) fuel our daily lives, powering 57% of global energy consumption. These fuels that we take for granted allow us to turn on our lights, drive our cars, and heat our homes. In 2019, natural gas was used by over two-thirds of Canadians in 7.2 million homes, businesses, and industries across the country. Our heavy reliance on these resources has led to the need for new and enhanced methods of energy production that have proven worse for our environment.
Conventional O&G extraction is obtained from deposits of oil and natural gas. After decades of extraction, most of these deposits have been discovered, contributing to the development of unconventional methods for drilling. The most well-known method is hydraulic fracturing, also known as fracking. This is done by drilling vertically into the earth, then drilling horizontally to allow oil and gas to flow to the surface and be collected and processed. While this increases the amount of oil available for extraction, fracking causes harm to the surrounding environment, impacting the people living in the region around the drill site. Up to 16% of hydraulically fractured oil is spilled annually, contaminating groundwater, streams, and water supply. 3.7% of natural gas produced in the US is leaked annually, releasing roughly 1.2 trillion cubic feet of methane every year, and polluting the air with smog and particulate soot. The resulting water, air, and health damages within single regions can cost millions of dollars annually. Not only does the extraction process have negative environmental impacts, but the burning of these fuels to produce energy contributes to 55% of total global carbon dioxide emissions.
It is these environmental impacts that have branded O&G as “dirty”, leaving this industry behind as investors shift to Environmental, Social, and Governance (ESG) investing. ESG are the three areas of interest for “socially responsible investors”. A driving force behind ESG awareness is the millennial generation that is making up more of the total pool of investors—90% of millennial investors are interested in pursuing investments that reflect the values they hold. Emphasis on ESG is growing, with one third of global assets under management expected to be ESG-related by 2025, meaning the pressure is on for companies to deliver on ESG metrics. As consumers and regulators put more pressure on traditionally “dirty” companies to become “greener”, the O&G industry must adapt its practices in order to become the future of ESG.
Capturing a Share of the Renewables Market
The O&G industry can capitalize on the growing electric vehicle (EV) market by positioning itself as a leader in clean electricity generation and using its existing real estate infrastructure to expand electric charging networks. With global EV market share expected to triple to 30% by 2030, there will be an increasing need for renewable electricity. While EVs produce 30-70% less lifetime emissions in most countries, those with the least emissions are in countries where most electricity comes from renewable and nuclear sources. O&G companies must therefore focus more of their resources on expanding their renewable electricity capacity.
The rapid integration of EVs will put a strain on global electricity resources, presenting an opportunity for O&G companies. EVs will require 640 TWh (enough to power 58 million single family homes in the US) by 2030, which O&G companies can supply through increased investment into renewable energy projects. In the past 5 years, the O&G industry has invested $60 billion into renewables, accounting for merely 6% of their total expenses. Despite the small percentage, some large O&G companies such as BP are setting ambitious targets of 50 GW by 2030, which would place it ahead of green energy leader Ørsted. With a current capacity of 2.5 GW, BP is estimated to spend $60 billion to reach its target. Much of the industry has been slow to adapt, but can increase its investments in renewable energy in order to play a key role in the expanding EV market.
In addition to supplying the renewable electricity demand for EVs, O&G companies should also invest in electric charging stations, which can be directly integrated into their existing real estate. With the growth trajectory of EVs, charging will become a bottleneck for integration. Large players in the O&G industry are already investing in EV charging companies to make these more accessible. As shown in Figure 1, Shell acquired multiple charging companies to increase its global charging presence to 134,000+ stations, and BP’s acquisition of Freewire Technologies will lead to the roll-out of 50 kW chargers at select BP fueling stations. The race is on to capture a share in this growing market, with O&G companies competing against EV giants like Tesla and its Supercharger stations. With its existing real estate and ability to supply clean electricity, the O&G industry is in a unique position to capture a share in the transition toward EVs. Beyond the EV market, hydrogen is a promising investment for O&G companies. This fuel can be used to replace traditional natural gas, producing zero emissions when burned. Hydrogen is produced using electricity, meaning this fuel can be completely renewable if produced using clean electricity (known as green hydrogen). More importantly, it fits perfectly into the gas industry’s existing infrastructure as it can be transported to homes through pipeline networks.
A concern is that hydrogen weakens and damages pipes, which is addressed by replacing metal pipes with plastic. It is estimated that 90% of the current piping system will be replaced by plastic by 2030, making hydrogen an attractive alternative to natural gas [Guardian]. As with most innovations, green hydrogen is significantly more expensive, costing 9 times as much as natural gas. This price barrier will shrink as renewable electricity prices continue to decrease, with experts expecting green hydrogen to cost less than natural gas by 2050 [Barrons].
Forming Partnerships to Achieve Dynamic Capabilities
With innovations comes new expertise demanded. In addition to the rising production delivery targets, O&G companies take on projects with increasing complexity—this is where collaboration comes into play. In recent decades, partnerships in the O&G industry have sparked new innovation and the mutual benefit it brings extends beyond business to business. It might be worth taking a step back to look at the collaborations strategically. Specifically, the point at which companies start to bring in outside talent to maximize outcome. The idea of dynamic capabilities is often alluded to in the technology sector but applying it here can shed light on the long-term tactics. Dynamic capabilities include integrating and recombining core operations and components at a system level.
Providing a foundation on the basis of partnership, dynamic capabilities play a role in different levels of operation. On the base level, projects are embedded in particular regions with their own supply, commercial, regulatory, and community dynamics, but must draw on common expertise, and experience. The middle includes integration at the level of the supply chain both for technology and quality, and finally at the full ecosystem level including setting standards and integrating the co-creators. Companies need to be strategic in forming their partnership to take on particular challenges through innovative avenues. It is crucial that the firm takes into consideration its existing assets and capabilities to, in turn, inform its strategy.
Taking past projects as an example, BP’s Thunder Horse South Expansion project is a prominent example of one that is extreme in its technological complexity, but fairly forthright in the institutional challenges the collaboration faced. The project took place in the deepwater Gulf of Mexico, which was within an established regulatory framework in a resourceful region with solid operatorship. This is when BP brought in Technip, now TechnipFMC, who had successfully made its name known through projects like Statoil Trestakk Oil Field Development in Norway, Sulphate Reduction Plant, in UAE and Liza Deep Water Project, Guyana. Integrating its expertise in project management, engineering and construction, Technip quickly brought huge success to the partnership. Specifically, the offshore installation was performed by Technip’s flagship vessel, the Deep Blue, one of the world's largest ultra-deepwater pipelay and subsea construction vessels. Thanks to the advanced technology and methodologies that Technip brought, BP was able to “bring the project onstream 11 months early and about 15%, or $150 million, under budget.”
On the other hand, when challenging projects fail to obtain talent from both dimensions, the results are consequential. Kashagan exemplifies a project which possesses high levels of technical and institutional complexity given the toxic nature of the reservoir and intricate geographic location. Moreover, the immaturity of the local regulatory framework together with mismanagement and the controversy around operatorship elevated the difficulty of the oil megaprojects. In this project, companies rushed into the oil extraction process which resulted in gas leakages and hydrogen sulfide mismanagement. On top of technological inadequacy, institutional guidelines were loose and ended the project with devastating results. Wildlife was severely affected and damages were long-term. By preliminary estimates,
The two aforementioned cases illustrate the importance of strategic partnership and tactical talent integration in the technological and institutional dimensions. While we do not have a crystal ball on the challenges future O&G companies will face, we provide a framework of integrative dynamic capabilities that have thrived in the scope of organizations that bear strategic lenses.
Reducing Emissions Throughout the Supply Chain
Beyond renewable technologies and partnerships, O&G companies can become more ESG-friendly by reducing emissions throughout their supply chain. According to McKinsey & Company, using the most cost-effective interventions, companies can reduce one tonne of carbon dioxide equivalent for $50. Right now, companies in Canada will have to pay $50 per tonne of carbon dioxide equivalent in Canada in 2022. This cost that companies incur will increase by $15 per tonne each year until it costs $170 to produce a tonne of carbon dioxide equivalent in 2030. If the companies are able to reduce each tonne of carbon dioxide equivalent by spending $50, they will become more profitable in the long run, as it will cost less to reduce the emissions than to produce them.
In the supply chain, 47% of emissions come from fugitive emissions, which is the controlled release of greenhouse gases (GHG) into the atmosphere during the production of oil and gas. By using vapour recovery units, which recover hydrocarbons to be used or reused as fuel onsite, companies would reduce emissions while also benefiting from the recovered hydrocarbons which could be used in future operations.
Recently, a new product has been introduced to the natural gas industry, known as “Green” Liquid Natural Gas (LNG). This refers to LNG in which the companies reduce or offset GHG emissions throughout their supply chains from upstream production, to liquefaction, transportation, and downstream use. Companies are reducing emissions in a number of ways including using biogas as feedstock—which is the raw material used to fuel the process to extract natural gas, reducing pipeline emissions, using renewable energy to power liquefaction facilities, and using carbon capture systems. Some companies are also participating in reforestation and investing in renewable energy to compensate for their GHG emissions.
There are many opportunities for O&G companies to reduce emissions throughout their supply chain. Doing this would not only improve the ESG factors of the company, but could also improve the profitability of the company, especially in the long run due to the high cost of producing emissions.
Clear Incentives for Becoming ESG Friendly
In order to quantify the benefits of reducing GHG emissions for corporations and shareholders, we examined five renewable energy ETFs and five O&G ETFs. We found that the top ten holdings in the renewable energy ETFs with a market capitalization of over $10 billion have a median Next Twelve Months (NTM) price to earnings (P/E) ratio of 28.1x, while the top ten holdings in the O&G ETFs with a market capitalization of over $10 billion have a median NTM P/E ratio of 12.3x. We also found that the EV/EBITDA ratio in the renewable energy ETFs have a median of 22.1x, while the O&G companies have a median EV/EBITDA ratio of 12.1x. The lower P/E and EV/EBITDA ratios for O&G companies suggest that investors are more pessimistic about the future of O&G companies than renewable energy companies due their environmental impact. However, O&G companies have a plethora of opportunities to reduce their emissions. Once O&G companies start shifting to become more ESG-friendly, investor outlook on the future of these companies will improve.
We also found that O&G companies have a lower return on assets and equity. Renewable energy companies have a median five year return on assets of 3.11%, and return on equity of 10.57%, while O&G companies have a median five year return on assets of 1.48%, and median return on equity of 3.17%. If O&G companies diversify into renewable energy, they would have a better return on their invested capital and equity, which would help companies generate more income. Since many O&G companies are cash heavy, they could diversify into renewables without diluting shares in the company, or raising funds through debt financing.
The O&G industry also stands to benefit from increased government support for ESG-friendly companies. Green energy subsidies currently account for around 30% of total energy sector subsidies ($187 billion). The amount is projected to increase to 65% of total energy subsidies by 2030 and a further 71% by 2050 [source]. This results from substantial commitments to environmental sustainability by governing bodies, with Biden’s newly proposed budget increasing spending on fossil fuel alternatives by 27% [source] and the EU planning to phase out all environmentally harmful subsidies by 2027 [source]. Pivoting towards ESG-friendly practices will allow O&G companies to benefit from the changing allocation of energy subsidies. Not only will O&G companies benefit from government support in the form of subsidies, but they will also decrease the risk of adverse government action—a significant risk for companies as shown in Figure 2.
The benefits of an ESG focus extend to the intangible realm, including positive brand perception as well as talent acquisition and retention. A strong brand is built on trust and transparency between a company and its stakeholders, which is exactly what ESG reporting offers. By aligning itself with certain values, a company is able to manage and strengthen stakeholder perception. This directly impacts the company’s talent pool, affecting talent acquisition and retention, employee motivation, and overall productivity. LinkedIn research found that 46% of professionals place strong emphasis on working for a company that has positive social impact, and a further 71% would be willing to take a pay cut to work for a company whose mission they believe in [LinkedIn]. Improving ESG practices would allow O&G to attract and retain top talent, which is an integral component of building successful partnerships. Both the financial and intangible benefits of ESG are the key to generating sustainable long-term growth benefiting O&G companies and their investors.
To Conclude
Oil and natural gas play a significant role in the world today, powering most of our day-to-day activities. Our reliance on these “dirty” fuels has caused irreparable damage to our environment, prompting the rise of ESG awareness that is placing pressure on the industry to adapt. O&G companies have a chance to capitalize on this trend by investing in renewable electricity to supply the EV boom and integrating hydrogen as a fuel in their gas operations. Beyond investing in renewable energies, the O&G industry can further offset and reduce emissions throughout their supply chain to rebrand themselves as ESG-friendly. Another way to rebrand is by expanding partnerships to advance sustainability development. As demonstrated in many instances in the O&G industry, partnerships can serve as a catalyst to drive this growth and innovation forward. Analyzing the success of historical partnerships, the integration of dynamic capabilities is at the core of manifesting optimal results. By taking these steps to become more ESG-friendly, companies will diversify their revenue streams, increase their return on assets and equity, and improve their stock multiples to increase the cash available for investment into the business. In the long-term, O&G companies will build positive brand perception and improve their talent pool. The incentives of becoming ESG-friendly are clear; by adapting its investments, practices, and partnerships, the O&G industry can continue to power our world while moving to the forefront of ESG.
