The Q1 2024 earnings season for the oil and gas industry has just concluded, and we’ve reviewed the results and analyst commentary. Financial discipline and return of capital were notable themes. Companies with streamlined operations and strong free cash flow generation leveraged these strengths to deliver returns to shareholders through dividends and buybacks while reinvesting in core operational activities.
Further, companies are increasingly focused on balancing shareholder returns with strategic investments geared towards long-term sustainability and resilience. This balancing act is critical as the industry navigates the dual challenges of ensuring profitability and aligning with the energy transition.
Companies have demonstrated varying degrees of success, with larger operators benefiting from economies of scale, leading to enhanced free cash flow generation and better capital returns.
As such, oil and gas M&A activity remains heightened, continuing the trend from previous quarters. The recently announced acquisition of Marathon Oil by ConocoPhillips suggests that this trend will continue. The consolidation drive is partly motivated by the need to achieve operational efficiencies and scale, necessary for competing in a market that increasingly values technological advancement and environmental stewardship as the hydrocarbon production business faces an inevitable decline. High-profile deals indicate an industry on a path to further consolidation, likely leading to fewer but more operationally efficient and better resourced players.
The Double-Edged Sword of M&A in the Oil Patch
The concentration of reserves among fewer, larger players has intuitive financial appeal. It suggests that better operators can leverage greater reserves to create more value and deliver higher returns. From a climate perspective, consolidation should also serve to reduce operational emissions, as the larger integrated producers generally have more efficient operations and lower Scope 1-2 carbon intensities.
However, a concentration of reserves into fewer hands brings risks that should not be overlooked. As the world transitions away from fossil fuels, the potential for these now concentrated reserves to become non-performative increases.
Analysts: Stranded Asset Risk Not Material
The notion of stranded asset risk, while common among responsible investors, is not yet considered a material near-term risk by the traditional oil and gas analyst community. While markets may imply that the immediate financial implications of future asset stranding are minimal (in part because security analysis is focused on the relative short-term), it is reasonable to assume that increasing oil and gas reserves, particularly reserves with a higher break-even cost, heightens the risks for acquiring companies.
Mitigating Risks Through Investment in Transition
Inherently, companies investing heavily in the energy transition become more naturally hedged against stranded asset risk — or the risks presented by a more sudden and abrupt transition to a low-carbon economy. Whether these investments are viewed as inexpensive options or low-cost hedges against future risks, they represent unrecognized value in the current market landscape. Our Transition Trackers analysis —which evaluates the stock performance of transition “Leaders” and “Laggards” within the oil and gas industry — indicates that the market is yet to value such transition-related commitments, actions, and investments.
Moreover, the scale of these investments is becoming increasingly viable. The capacity growth of solar, wind, storage and the global momentum (ex-US) of EV sales suggests that clean energy solutions will continue to take market share. While the stock performance of public clean energy companies has lagged the broader market, the growing adoption of all things clean suggests that the value of these ‘options’, or ‘hedges’, is growing. This growth in the green sector not only highlights the potential for a sustainable transformation within leading oil and gas firms but also underscores the increasing attractiveness of these investments to both the oil and gas companies themselves and their shareholders.
The Investment Thesis: Leaders vs. Laggards
As we look to the future, institutional investors are left with critical questions:
- Is the upside potential of the ongoing oil and gas M&A wave largely over?
- Is it strategically sound to own a portfolio of assets that present lower risks?
- What does this mean for the planet?
In answering these questions, one can envision a strategy whereby investing in a portfolio of Leaders — those integrated firms that are not only managing significant oil and gas reserves but are also actively investing in the transition to a low-carbon future — potentially offers a more promising and responsible path forward. Not only does this strategy better align with broader environmental goals, but it also positions energy investors in a way that aligns with the significant shift in energy production that will redefine the industry’s landscape in the coming years.
David Root
Head of Client Engagement
FFI Solutions