The Saudi oil minister who is said to have masterminded the oil crisis of 1973 died last week. His passing may also mark the ending of the era of the oil boom.
While the price of oil is now back to pre-lockdown levels, last month Standard & Poor’s put 13 oil companies on downgrade watch, citing profitability concerns to the oil and gas industry, in part driven by the green energy push. It comes on the heels of 46 bankruptcies in 2020, including the multi-billion dollar failures of Chesapeake Energy, Ultra Petroleum, and Unit Corporation.
Fossil fuels globally are expected to grow 24% by 2050, while renewables will grow 137%, according to my calculations based on data from the U.S. Energy Information Agency. Oil and gas is clearly not dead, but the boom has been eclipsed. Growth concerns aside, there are some fundamental problems in the industry, and investors are finally taking notice.
Over 1,300 institutions have now divested more than $14.5 trillion from fossil fuels. Many of these divestments may be related to the climate crisis as well as newfound interest by investors in environmental, social, and governance factors. But systemic profitability issues predate the ESG movement, and might be motivating factors for some investment boards.
My 20-year career determining the creditworthiness of countries as a sovereign analyst forced a rapid learning curve on the oil and gas industry. In 2016, I met with the treasurer of the national Mexican oil company, Pemex. He informed us they were not forecasting any free cash flows within their projection horizon. Free cash flow is the difference between the cash received and the cash outlays for operating costs. In plain language, Pemex was in trouble, and were it not for government support, it would have filed for bankruptcy.
Perhaps more alarming than a finance chief plainly stating the company is not profitable is that his remark was not met with any alarm. Those of us present knew that the oil fields were running low, the cost of drilling for that extra marginal barrel required technology they did not possess, and the margins on refining the oil were too thin to warrant further investments. The Mexican government was not going to let the bonds default, so nothing to see there. The situation remains the same today: Pemex continues to have negative free cash flows, and the government continues to provide cash infusions.
Equally eyebrow-raising is that Pemex has not successfully pursued plans for fracking its vast fields of methane. Mexico has some of the largest shale oil reserves in the world, and given Pemex’s financial woes, tapping that resource should have been easier than reaching into a cookie jar. But the country’s president turned down a fracking proposal. Many reports attribute the rebuke to environmental concerns, but my conclusion is that the real driver was profitability, which in some ways related to limited water resources needed for fracking.
Fracking promised abundant oil supply in America. It has been a disappointment. It turns out, fracking requires a large capital investment to drill and wells typically face a steep decline rate of 75-90% in the first three years, though they were meant to last 20-40 years. This makes shale oil reserve estimates highly optimistic. As a result, the production of one well is insufficient to pay the debt accumulated for it. New loans are then taken out to drill a new well, the revenues from which go to pay off the loans from the first well. This keeps working so long as gas prices continue to rise, or new discoveries are made on land previously leased by the companies. When that fails, so does the company. In many ways gas frackers are more like real estate bets linked to oil and gas prices than true energy companies. And in many cases, they’re government-subsidized.
Mexico is not alone in its efforts to prop up flagging fossil fuel companies. The U.S. government has been providing annual subsidies to the tune of $20.5 billion as of 2017 even as analysts warn about lack of profitability, especially in shale oil and gas.
Chesapeake Energy’s $9.5 billion loss, for example, was a failure in the works for many years. Yet, similar to the way investment managers continue to hold Pemex, they also continued to hold Chesapeake—ample liquidity kept the wheels turning—until they stopped.
Chesapeake has now emerged from bankruptcy, and word on the street is fracking is back, 3.0 style, meaning they will try to operate profitably. Fracking’s history does not lend to much credibility. But maybe this time they mean to make an honest go; maybe now the technology is better; maybe this time they can get it right? After all, companies like EOG Resources so far have managed to stay profitable.
Maybe. But will oil and gas be more profitable than renewables? S&P seems to have doubts.
If you, whether an individual investor, or as a representative of an endowment or foundation have not divested of fossil fuels, insist on the simple questions: Is my oil and gas portfolio profitable? Can the companies stand without government support? Do they have free cash flows from which to comfortably operate and invest?
If there are oil and gas companies that pass the basic profitability test, the next step is to look how they compare to renewables. Finally, consider whether the portfolio you own reflects your values, or the values of the institution you represent. However you feel about fossil fuels, the answers to these questions may surprise you.
Bianca Taylor is founder of Tourmaline Group, an ESG research boutique, and is a public voices fellow with the OpEd Project and the Yale Program on Climate Change Communication. She is also a member of the Bretton Woods Committee.
