For global oil and mining companies to achieve low-carbon transition, they must adopt a transition growth mindset while nurturing legacy cash cows, incorporate transition risks and rewards in investment decisions, and use new business models to enable growth and close valuation discounts, says a new report by Wood Mackenzie.
The global energy research firm said that companies in the energy and natural resource sectors struggling to balance satisfying shareholder returns and meeting stakeholder low-carbon demands can leverage these strategies to drive capital allocation decisions toward growth and closing valuation gaps.
“Last year, energy security trumped sustainability. Companies have benefited from recent commodity prices and margins to deliver record cash flow,” said Tom Ellacott, senior vice president of corporate research for Wood Mackenzie.
“That is not to say that decarbonisation goals cannot be met and priorities cannot change. But to spur activity, there needs to be a recalibration of current risks and rewards for investment in low-carbon technologies, as well as new incentives from government stakeholders and financial institutions.”
Ellacott further said that there is no one answer, but smart oil and gas and natural resources companies will realize that protecting the status quo would be a mistake and start to manage their portfolios to reflect a balanced approach to managing legacy output and carbon management.
Tend to the legacy cash cows while shifting to a transition growth mindset
According to the energy consultancy firm, investors expect companies to balance the need for returns in the short term by tending to their legacy portfolio while delivering low-carbon transformation plans.
Nurturing legacy cash cows means maintaining and supporting existing profitable products, services, or businesses that have been a reliable source of revenue for a company over an extended period.
“The visibility of low-carbon profit centres starting to support and supplant legacy cash cows could be a revaluation trigger that shifts the market to a transition growth mindset,” the report said.
“Companies can scale back share buybacks to fund the shift. The mining majors and international oil companies allocated $157 billion, or 30 percent of their operating cash flow, to buybacks in 2022. Companies could still grow base dividends and lift reinvestment rates to over 60 percent.”
Bend hurdle rates to reflect transition risks and rewards
The energy research added that internal hurdle rates must follow the divergence in external capital costs, risk, and long-term growth potential. Risk avoidance and optionality are part of the low ‘return’ of transitional investment.
“Higher returns could be up for grabs in low-carbon projects with greater commercial risk, such as CCUS developments that include carbon price risk. In times of uncertainty, companies need a larger portfolio of options to manage risk. Use a suitable hurdle rate for the opportunity,” the report said.
Use Mergers and Acquisitions (M&A) and new business models to enable growth and close valuation discounts
Major oil companies are already using M&A to accelerate expansion into low-carbon businesses, such as biofuels, biogas, and renewable power. However, overall capital allocated to low-carbon M&A remains limited. Mining majors continue to take a low-risk approach to acquisitions of transition-focused commodities.
According to Wood Mackenzie, new or modified business models can help reduce the transition valuation discount and support efficient capital allocation in businesses with quite different costs of capital and risk-reward profiles.
“A transition growth mindset does not mean abandoning capital discipline if combined with risk-adjusted and transparent hurdle rates. There are different horses for different courses, depending on a company’s scale, portfolio make-up, geographical focus, and legacy skillset,” Ellacott said.
“The prize is worth fighting for: bending the carbon curve to limit the world’s temperatures to well below 2 °C. And a balanced, disciplined, transition-focused investment approach could grow corporate cash flows sustainably, boosting company valuations.”
The energy firm further said that expected reinvestment rates (investment as a percentage of operating cash flow) in oil and gas companies and miners of between 40 percent and 50 percent trail the investment rates of utilities chasing growth. Reinvestment rates in both sectors have been trending down since the middle of the last decade.
In large part, this has been due to strategies such as capital restraint and massive buybacks that have been successful for companies and investors, the energy consultancy firm said. The oil and gas, metals, and mining sectors have outperformed the broader market by 44 percent and 16 percent, respectively, since the end of 2021.
“Realistically, the only way to change investor sentiment is to bring about further shifts in the risk-reward equation. We will have to see this in a variety of ways. Examples are government support schemes like the Inflation Reduction Act in the US, regulations such as the European Carbon Border Adjustment Mechanism, or customer-driven market creation, such as a willingness from consumers to pay premiums for low-carbon energy,” Ellacott said.
“Financial institutions could also play a big part by punishing slow-to-change companies with higher borrowing rates. Hopefully, this will drive new investment inflexion points that will catalyse more activity for low-carbon energies.”
Wood Mackenzie added that wind and solar have passed through inflection points and are scaling rapidly, thanks to strong capital infusions. A similar point will have to be reached for the energy transition support system: metals, CCUS, bioenergy, hydrogen, and charging infrastructure.
“The evolution of policy is a big unknown. Companies may face the capital allocation dilemma of high hydrocarbon returns versus lower-risk, lower-return transition-enabling projects for decades yet,” said James Whiteside, head of corporate metals and mining for Wood Mackenzie.
“Rather than chasing carrots or ducking sticks, companies need to develop robust strategies to navigate the unfolding regulatory landscape of the energy transition. The metals most exposed to the transition, such as lithium and rare earth elements, have garnered more media attention than established commodities such as nickel, copper, and aluminum. But these base metals need to mobilise the most growth capital to achieve climate goals.”