Demand for environmental sustainability could lead the oil and gas industry on a path to financial sustainablity, through long-term offtake agreements for low or zero emissions output. These agreements would in turn produce stable cash flows, making oil and gas companies more financially sustainable, which would lead to higher market valuations.
Oil and gas.
The words alone seem to be contradictions, but they don’t have to be. “Sustainable” actually means “able to be maintained at a certain rate or level.” A “sustainable oil and gas industry,” then, just means one that can continue in business. And while the oil and gas industry has often been at odds with environmentalists, environmental sustainability could in fact be the key to a more sustainable oil and gas industry from a business and financial point of view.
To start, let’s review some basic facts:
- Renewable energy (wind and solar) are now the cheapest sources of energy.
- However, renewable energy is not always available. Wind and solar output vary through the day and seasons, and they also vary depending on the location.
- The cost of renewable energy is almost all upfront capital investment. There are no fuel costs to get wind and solar energy once they’re set up. This locks in the long-term cost of energy once the initial investment is made.
- Renewable energy produces energy without Greenhouse Gas (GHG) emissions.
So how do oil and gas stack up against renewable energy? Their biggest advantage is that they can be “always on”–they can provide energy wherever and whenever needed. Their biggest disadvantage is the GHG emissions that contribute to climate change.
In our book, however, we talked about how the oil and gas industry could produce low and even zero emission energy through a variety of technologies, including carbon capture and storage (CCS), sustainable biofuels, and hydrogen. All these technologies involves large upfront capital costs and will make these fuels more expensive, but it will also put them on a level playing field with wind and solar from an emissions perspective. As a result, they could be a premium alternative to wind and solar, offering a high intensity, always on source of energy where it is needed.
These low- or zero-emissions fuels will require significant additional infrastructure, for example to capture, transport, and store the carbon emissions; to refine food waste into fuels; and to create hydrogen with natural gas while capturing and storing their carbon emissions. Thus, their value would depend on the availability and cost of the new infrastructure, which the energy users will need to secure. At the same time, as they become more accustomed to the economics of wind and solar, which requires large upfront capital investments but locks in the long-term cost of energy, we would expect them to similarly be comfortable with, and eventually even prefer, locking in the long-term cost of low- and zero-emissions fuels.
All these trends point to an oil and gas industry which will evolve towards the following characteristics:
- Oil and gas will be paired with new infrastructure to eliminate their emissions.
- Oil and gas will no longer be commodities. Instead, their emissions attributes will be critical drivers of their pricing.
- Customers will enter into long-term off take agreements for oil and gas with guaranteed emissions targets.
- These long-term agreements will eliminate customers’ energy price risk and provide stable cash flows for the oil and gas industry.
- Stable cash flows will give higher valuations to oil and gas companies and allow them to access funding on more favorable terms.
In other words, environmental sustainability could lead to financial sustainability for the oil and gas industry.
We believe not. Something similar is already happening with methane reduction, another topic discussed in our book. Methane leakage and flaring in the oil and gas industry cause the equivalent of billions of tons of GHG emissions every year, as well as billions of dollars of lost output. As a result, the industry has rallied together to eliminate these emissions through coalitions such as the Oil and Gas Methane Partnership and Our Nation’s Energy Future. Today, just about every major oil and gas company has set targets for reducing and eventually eliminating methane leakage and flaring.
As enough of the oil and gas industry makes the investment to monitor and fix the methane problem, they would naturally seek a return on their investment by differentiating their output. The logical next step would be to go to their customers–utilities, airlines, and industrial manufacturers–and get them onboard to use only oil and gas which meet targeted methane levels. Finally, to protect their collective investments, all these industries would support government regulations to protect against “carbon leakage,” following the examples of the EU’s Cross Border Adjustment Mechanism or the recent Inflation Reduction Act in the U.S.
Over time, we would expect to see this pattern repeated. Oil and gas companies which make the investment to reduce methane and other GHG emissions will try to differentiate their products based on their emissions attributes. Thus, what was once a volatile commodity business with huge swings could become financially sustainable with stable cashflows and higher market valuations.
In summary, a sustainable oil and gas industry is one which:
- Meets environmental and emissions requirements of the general society.
- Sells under long-term offtake agreements with guaranteed pricing.
- Earns stable cashflows and returns.
- Commands high valuations in the stock market and favorable rates and terms from lenders.