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Oil and gas: A question of capital allocation

The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Calvert disclaims any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Calvert are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Calvert fund. References to individual companies for Engagement or Research purposes are provided for illustrative purposes only and may not be representative of the results of all of Calvert’s engagement efforts. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Past performance is no guarantee of future results.

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      By John MillerVP and ESG Senior Research Analyst, Calvert Research and Management

      Washington - Through 2019, the oil and gas sector (energy) of the S&P 500 returned over $65 billion in capital to shareholders via dividend payments and share buybacks. When large-cap European and Canadian oil and gas companies are added, shareholder distributions climb to above $110 billion.1

      With the outlook for 2020 and 2021 sector distributions higher than those paid in 2019, the pressing question stands: Why are oil and gas management teams running their businesses for cash, at the expense of growth or investment?

      When asked, the response from sector management teams is consistent: Oil and gas companies are maintaining a laser focus on capital discipline (i.e., limited organic and inorganic capital expenditures) and increasing shareholder distributions because this is what investors are demanding. Historically, oil and gas firms have failed to manage the cyclical nature of commodity cycles, expanding capital expenditures when commodity prices are high, only to be overlevered and overproducing when prices inevitably roll over. Management teams state that the current capital allocation strategy is merely a reflection of recurring cyclical trends within the space.

      An alternative read leads to a vastly different conclusion. Namely, what if this is not a reflection of a "typical" oil and gas commodity cycle, but rather the rumblings of an evolutionary change in energy market demand?

      Follow the distribution of capital

      At the highest level, company management teams in any industry must make strategic decisions on how to allocate the cash generated by business operations. If the company believes that market demand for its products and services will grow, it invests in capital expenditures to grow organically or inorganically (via M&A). If the company does not see growth options, or believes that investment returns on growth opportunities are too low, it will then distribute capital back to investors via dividend payments and share buybacks.

      The oil and gas sector's massive distribution of capital back to investors can potentially indicate that it does not see economically viable growth opportunities in traditional fossil fuels. Further, investors may not want oil and gas companies to continue upstream investment back into the space.

      Equally problematic, to support the scale of current distribution levels, which are often not fully funded by free cash flow, oil and gas companies have turned to asset sales and borrowings, increasing net debt.2

      Why so? Accounting directly for 9% of all human-made greenhouse-gas (GHG) emissions, and a further 33% when final fuel consumption is considered (for a sector total of 42% of all GHG emissions), the sector is increasingly pressured by the transformation to a low- or zero-carbon life cycle energy economy.3 More specifically, oil and gas demand is challenged by the "energy transition," or the ongoing transformation of the energy supply, transmission and distribution systems, with the objective of delivering a lower-cost, more resilient and more sustainable energy system.

      The energy transition, and the subsequent decline in global oil and gas demand growth, is no longer an abstract future concern. It is happening right now, with current US oil and gas reserve life holdings averaging 13 years of production.4 These assets extend through an increasingly uncertain global demand footing.

      Bottom line: Calvert is a long-term investor, seeking to motivate positive change in the companies in which it invests. With a flat demand outlook and deteriorating economics, we believe the traditional oil and gas space remains broadly unappealing when measured against fast-growing renewable and low-carbon alternatives. This outlook is supported by the capital allocation decisions of the most effective oil and gas companies.