Can Oil Majors successfully reinvent themselves？
Victor Liu, Ph.D.
Oil giants have finally decided to ride the wave of green energy revolution. Their financial capacity will change the landscape of the renewables industry. Does the green move make economic sense? Can they turn themselves into heavyweights of renewables?
Until 2019, there were few signs of a major shift of investment from big international oil companies (the oil majors). Capital expenditure outside core business areas had been less than 1% of the total.
But now, many oil majors seem to be fully onboard. Their seriousness about clean energy was underlined recently with a run of large-scale renewable investments.
BP said it plans to build 50GW of renewables by 2030 and have just made its first foray into the offshore wind market in British waters. Together with its German partner, EnBW, BP just committed to pay a total of £3.7bn in four years for options to develop 3GW of wind power in the Irish Sea.
In the same offshore wind auction, a partnership of Total and Macquarie secured 1.5GW of leases. Separately, in January Total announced to pay $2.5bn for a 20% stake in Adani, the world’s largest solar developer. These green investments are part of Total’s business plan to spend at least $3 billion a year on renewables by 2030.
The math is simple. On average the oil majors now invest $20bn a year each. With the likes of Total and BP spending $2-3bn on renewables annually, they are redirecting 10-15% of their investment to green energy themes.
1. Making economic sense
On the face of it, international oil companies’ recent bets on renewables show that they are finally bowing to growing social and environmental pressures. But, deep down there are persuasive economic drivers for the fossil players to embrace clean energy.
Even before the 2015 oil price crash, the margin of the oil giants was already strained. As conventional oil reserves depleted quickly and oil-rich countries tightened their grip on domestic resources, oil majors are left with no alternatives but to drill in deeper, remoter, and less prolific regions around the world.
The resulting drilling adventures into the likes of deepwaters in West Africa and heavy sands in Canada led to soaring marginal costs, making continued replacement of oil production increasingly untenable.
Then, the shale boom began. Smaller independent shale producers ramped up production and cut costs, leaving a world with ample supply and halved oil prices.
So, the oil majors were already struggling even before the onset of the energy transition. It would make sense for them to diversify if renewables were a plausible pathway. However, the scale and return of most new energy projects had been a long way from their traditional fossil ones.
But now, the winds have changed and the renewable market is starting to present sensible opportunities for big oil companies.
First, renewables are becoming increasingly cost-competitive compared to hydrocarbons. Renewable costs are down c.80% over the past decade and are expected to fall further. And in many places, subsidy-free solar and wind are already cheaper than their fossil counterparts. This makes utility-scale renewable projects economically viable and sustainable.
Second, renewable projects are getting larger and more complex, thanks to advances in frontier sectors such as offshore wind, clean hydrogen, and integrated power solutions. The financial capacity and mega-project experience of the oil majors can play a central role in helping to scale up the development of these new solutions.
Third, so far, the largest portion of renewable spending are based in countries with sound infrastructure, supply chain and market systems. China, the US and Europe accounted for almost 70% of the global renewable investment in 2019.
This is going to change. The oil industry was established in the US in the late 18th century. But it is the likes of the Middle East, Eurasia and Latin America that has become the crude exporting hubs since the 19th century.
The renewables industry will likely show a similar geographical dispersion. With plenty of low-cost solar and wind resources and vast empty space, regions such as the Middle East, North Africa and West Latin America possess enormous potential for utility-scale renewable developments.
Interestingly, these promising lands broadly overlap with oil majors’ international coverage over the past century. The oil giants have first-hand experience and in-depth knowledge in these regions on everything from geopolitical factors to the local supply chain. And in turn, they have a natural advantage to accelerate the geographic expansion of green energy.
All these have led to the current wave of green initiatives and substantial investment from the likes of BP, Total, Shell and Eni. Broadly speaking, these green moves are in the right direction.
But will the oil majors’ transition in this global energy shift be a smooth sail? What are the challenges they may face in the journey? Let us look at the key ones.
2. Triple challenges
The renewable shift will certainly take oil companies out of their comfort zone and present new challenges. Here are the three key ones to watch closely:
The first is a financial one. Investors have been sceptical that big oil companies can achieve similar financial returns from renewable investment as they can from their core hydrocarbon activities.
This scepticism makes sense. The financial characteristics of renewables will be quite different from oil and gas. The oil industry has historically enjoyed double digit returns. But the margin for renewables is usually much lower.
Tighter margin expectations imply little room for mistake and high requirement for standardisation of activities. But tight cost control, agile project execution and standardised procedure are not always achieved in the fossil industry. Many oil companies suffered from chronic delays and cost overruns in complex offshore oil developments. They need to proof that they can truly deliver renewable projects in a cost-effective manner.
Furthermore, as oil majors venture into the renewable market, everyone should expect competition for large projects to become more intense. An increasingly crowded market will further suppress project margin.
In the offshore wind auction mentioned at the beginning of this article, BP’s bid for megawatts of capacity was 65% higher than the second most expensive lease awarded. Despite being a premium acreage, the high prices paid for it still surprised many. In fact, as BP’s bid was so surprisingly high, the authority had to issue a clarification later confirming that the number was not an error.
To oil majors, the high cost is necessary for securing premium resources and kicking off at-scale projects. In addition, these costs represent a long-term investment in their ability to remain relevant in a carbon neutral world.
With ample cash in their fossil-financed war chest, they can make the renewable pie bigger as well as grabbing a large slice of it. It is not clear that whether this trade off could maintain the balance of the renewable industry. And it is also not certain whether the oil companies can achieve a desired return of 8-10% from their big renewable investments.
The second challenge facing oil companies is a technological one. As opposed to the mature oil industry, the renewable market is still an emerging sector with fast-pace changes in technological solutions and pathways.
Renewable players are not sitting on existing technologies. Instead, they push for innovation and base their investment assumptions on more cost-effective future solutions. And innovation is especially key for the frontier green sectors such as floating wind and green hydrogen, of which the optimal solutions are far from certain.
To adapt for the fast-evolving environment, oil majors need to adopt a new mindset that embraces innovation, R&D, supply chain collaboration and procedure optimisation.
The third challenge is related to the business case. Oil majors have a proven business model that integrates upstream and downstream activities, which for decades has generated lucrative returns. However, their winning formular for the renewable sector is yet to be formulated.
The renewable market is more fragmented and decentralised, making it hard to concentrate resources into a handful of mega projects. And the business model is not yet clear for many emerging green sectors such as clean hydrogen, carbon capture and storage, and integrated energy systems.
And when oil majors enter the electricity grid market, the “downstream” of renewables industry, they will face established incumbents in almost any countries in the world. This could make a vertically integrated business model highly challenging.
That said, the learning curve will be steep for the Oil Majors to work out their winning business model in the renewables market.
3. Big Oil to Big Energy
So, with both opportunities and challenges abound, what will be the future look like for the oil giants? Can they successfully reinvent themselves in the face of this global energy transition?
It is not going to be easy. Now oil companies need to simultaneously deal with a COVID-led demand slump to restore profitability, fight an uphill battle to slash emission, and venture into the renewable arena to secure their future.
In this backdrop, strengthening their operational and financial structure is a priority. In addition to the announced cut of capital investment, consolidation might make sense in this turbulent time.
In the late 1990s, when facing adverse market conditions, international oil companies consolidated into a handful of oil majors that we know well today. Now, the market environment is even more challenging. Hence, further consolidation can be an important step to build the scale, strength and efficiency needed for navigating this grand transition.
Nevertheless, despite multifaced challenges, international oil companies still have plenty of time to adjust and transform themselves. Today, we still need close to 100 million barrels a day of oil production, or 33% of the global energy demand. And a substantial amount of crude and gas will still be needed for at least 25 years, according to even the most optimistic forecasts of renewables penetration.
In the meantime, blue energy, which refers to fossil activities coupled with carbon capture and storage (CSS) solutions, might offer oil majors with an intermediate step towards clean energy. I borrowed this ‘blue’ label from the three-colour theme of the hydrogen industry, where grey hydrogen is derived from fossil fuels, blue hydrogen is the grey one coupled with CSS, and green hydrogen is produced using renewable electricity.
As of today, around 15% of global energy-related greenhouse emissions come from the oil and gas value chain. Reducing emissions from oil production through CSS solutions is the low-hanging fruit for the majors. By minimising flaring of associated gas and venting of CO2, tackling methane emissions, and integrating renewable electricity into new upstream developments, the IEA estimates that oil companies could reduce their upstream emissions by more than 40% by 2030.
To achieve that, oil companies need to take the challenge to optimise the CSS technology and business model. They are already the pioneers of the technology. And with tightening carbon polices and technological advances, cost-effective CSS solutions have a potential to provide a renewed life for the majors’ hydrocarbon reserves. This would buy them time and room for an orderly transition towards zero carbon energy.
Besides, in the long run, continued investment in the renewable market will bear fruit if done right. Some of the oil majors have the chance to really transform themselves into global energy majors.
If the ventures succeed, the majors will possess arguably the best portfolios in energy with an optimal composition of near-term cash cows and strategic long-term assets. Their primary activities will be mega-projects such as offshore wind and green hydrogen in resource-rich regions around the world. And they should be able to make some penetration into the new midstream infrastructure and grid businesses. And the majors might then be worth more than what the public market valued them today.
Nevertheless, to realise this vision is much easier said than done and the journey from big oil to big energy is bound to be bumpy. The oil giants need to adopt a new, coherent strategy and well-balanced approach to upgrade their core competences and tackle the multifaced challenges through the coming decade. This is surely a daunting task, but at least there is hope for a clean and bright future after the long haul.