Capitalizing on the financial incentives afforded to renewable projects and societal preferences towards new energies, the investor community has become one of the four forces of the energy evolution. In today’s blog, we will examine how and why investors have shifted their capital towards new energies and discuss what this means for the future of the energy mix.
To begin the story, lets start with how and why the investor community soured on oil and gas investments most recently. We will keep the story as short and simple as possible, although there could be (and are) whole books written on the topic and there were many ups and downs throughout the process. It begins with a success story, one where the United States unlocked its shale resources rapidly, cut costs, and gained efficiencies to make its production of oil and gas resources competitive with the lowest cost producers in the world. With its ample resources and short cycle times, it became the swing producer of supply, setting the margin. In the process, OPEC’s influence on the markets was diminished and prices stayed low thanks to the competitive exploration and production (E&P) market in the United States. The United States’ surging production made it the global producer to beckon with. This story was made possible by the availability of capital to the oil and gas space. However, rewinding back to several years ago, even before the COVID pandemic, the most important thing to investors, returns from the capital outlay in oil and gas, started to come under scrutiny.
In the early days of the shale revolution, single well Estimated Ultimate Recovery (EUR) and economics, along with inventory of drillable locations, were the driving forces of the capital outlay. However, the nature of shale declines, spacing issues, variable productivity of acreage, and sustained lower prices left the expected returns short. In essence, the E&Ps were not returning cash to shareholders to the investors’ liking. The investment community started to focus on maintaining operations within cash flow and diverting the excess cash flow from the drillbit to the shareholders. This rapid shift in the goal posts for E&Ps meant they had to adapt, which caused several years of hardships (exacerbated by the COVID pandemic’s impact on demand). E&Ps focused on cash flow from operations, quality of inventory, and the economics of their assets (a shift away from the single well focus). This led to a decline in pace of drilling and consolidation among other measures. Furthermore, the investor community’s insistence on returns to shareholders in lieu of reinvestment in operations meant that, even once the excess cash flow started to be realized and returns to shareholders were materializing, the E&Ps continued to exercise caution in the allocation of excess cash flow back to operations. Furthermore, there was a continued shift of new capital away from the oil and gas sector.
In fact, while the E&Ps were aligning to the world of living within cash flow and returning it to shareholders, more headwinds were coming to the forefront. Investors were becoming one of the four forces of the energy evolution. Societal preferences were driving scrutiny on environment, social, and governance (ESG) related workings of target investments. The emissions footprint of the E&P sector was under the microscope and investors demanded better tracking and curtailment. Additionally, there was a shift to allocate more and more capital towards new energies. These investments had tailwinds from policy, consumer preferences, and continued efficiencies and cost cutting. In many ways, investors saw this as an alternative to investments in the oil and gas sector. Figure 1 shows how the mix of private equity capital raises in energy has trended towards renewables funds (left graphic). In fact, of the $37.5 billion of capital raised in 2021, 80% are for renewables with a further 16% being mixed conventional and renewables funds. Additionally, the chart on the right shows that more than 1,400 public institutions with more than $14 trillion under management have decided to divest away from hydrocarbons.