Sustained low oil prices will ‘decimate’ returns from new oil and gas projects but clean energy could emerge stronger, Wood Mackenzie suggests
Wood Mackenzie believes that although the oil price war and oil companies’ reduced cash flow could slow down the rate at which the oil majors make progress on carbon reduction, global growth in renewables will not be affected.
What’s more, at US$35/bbl, renewables can compete with oil and gas projects. “In a US$35/bbl oil price environment, investment in renewables represents an opportunity for companies with strong balance sheets, which are in position to think strategically and long-term. Diversification into clean energies could ensure their long-term survival,” Wood Mackenzie said. At the time of writing, the price of Brent crude had slipped below US$35 to US$27.5/bbl.
Wood Mackenzie’s analysis shows that at or below US$35/barrel, 75% of pre-final investment decision (pre-FID) projects globally would return less than the cost of capital, assumed at 10%, and renewables projects therefore now look as attractive as upstream oil and gas projects.
“With a weighted average return of 6% IRR, oil and gas projects are now in line with average returns from low risk solar and wind projects,” Wood Mackenzie said. “Capital allocation is no longer a one-way street for Big Oil – renewables projects suddenly look as attractive as upstream projects at US$35/bbl.
“The energy transition will carry on regardless, building momentum,” said the consultant. “At the same time, investors, regulators and consumers will continue to put pressure on oil and gas companies to reduce or neutralise carbon emissions. These pressures will only increase as investors consider the characteristics of investments in oil and gas: low return, high volatility and high carbon.
“We are not arguing that the oil price stays at US$35/bbl forever. But the analysis highlights the relative risk in upstream compared with renewables,” the company said.
“The higher cost of capital in upstream, and hurdle rates, reflects the risk – the volatility of future cash flows depending on the oil price outturn. In contrast renewables cash flow is more stable, predictable – and bankable – and has a commensurately lower cost of capital.”
Wood Mackenzie believes that global renewables growth will not be affected by the oil price war because historically, the oil price has not shown any correlation with investment in renewables. Most investment comes from outside the oil and gas sector which accounts for less than 2% of global solar and wind capacity. “Even if Big Oil stopped investing in renewables altogether, it would have a minor impact on growth,” it said.
Wood Mackenzie’s analysis shows that installations of wind and solar continued to increase through the last oil price downturn. “While we may see some slowing of investment in renewables in hydrocarbon exporting countries due to downward pressure on budgets, these investments are a relatively small piece of the global renewables,” it said.
Since 2016, the European majors have invested around US$10Bn in different clean technologies, including solar, onshore and offshore wind. Shell and Total have expanded their new energies portfolios across the electricity value chain. But this investment is only a fraction of what they have invested in their oil and gas businesses, accounting for less than 5% of total capex.
The majors’ capital allocation strategy has been underpinned by prudent investment in high return projects, especially since the oil price downturn in 2014. ‘Competition for capital’ between different projects has been a key mantra. At US$60/bbl, solar and wind assets – with average returns of 5-10% IRR – have found it difficult to compete with expected double-digit returns from oil and gas projects, despite the much lower technical and commercial risk of renewables. Having both oil and gas and renewables projects within the same capital structure made it very difficult for the majors to allocate significantly more capital to renewables.
“Expected returns from renewable projects are generally below the cost of capital of an oil and gas company, but the recent sharp fall in oil prices is likely to push the sector into a new paradigm and companies will be testing their future oil and gas investments against a more conservative oil price assumption.
“In a sustained US$35/bbl oil price environment, the argument that ‘investing in low-return renewables project would leave value on the table’ no longer holds,” Wood Mackenzie concluded, “and even if the oil and gas sector stopped investing in renewables altogether, the growth trend in solar and wind would not be reversed.”