Big Oil will miss the financial discipline imposed by ESG

FOSSIL-FUEL investors may come to mourn to their years in the wilderness. It is true that the rise of ESG concerns made oil, gas and coal almost un-investable. But, even truer, it drove valuations to bargain levels, and imposed a cost discipline and a focus on shareholder returns that are funding today’s dividends.

For the brave, Big Oil’s time in investment purgatory offered a once-in-a-lifetime buying opportunity. Nathan Rothschild’s advice to “buy when there’s blood in the street” is a favorite of contrarian investors. And, between 2018 and 2022, there was a lot of red spattering the charts, especially in mid-2020 when the pandemic hit, driving prices to ridiculously low levels.

At one point, ExxonMobil, the world’s largest international oil company, traded below the value of its assets. On a share-price-to-tangible-book-value ratio, it changed hands at 0.65 times in March 2020, down from an average of about three times during the previous 20 years, according to data compiled by Bloomberg. Today, it trades at 1.8 times.

Trading at depressed values, the industry slashed capital investment. Instead of spending money on new projects, companies channelled cash into dividends and share buybacks, as well as paying down debt.

Some, including BP and Shell, even went as far as announcing plans to curb production, in effect curtailing future cash flows. The effects of that capital straitjacket would show up, over time, in lower production growth – great news for investors who kept the faith with Big Oil by presaging higher commodity prices on the horizon. 

Now, companies that once focused on burnishing their ESG credentials are abandoning those efforts. It is clear that the ostracisation of fossil fuels is over (except in pockets of Europe). In energy, ESG has gone from hottest item to demode in fewer than five years.

During the second quarter, energy executives mentioned ESG only 755 times in earnings calls, down from a peak of 2,170 times in Q1 2021. The same goes for “emissions”, a proxy for the sector’s focus on climate change. In Q1 2022, executives use the word a record 1,132 times in calls with analysts and investors; the count dropped more than 80 per cent to just 186 mentions during the last quarter.

Anecdotally at least, mainstream US investors are making a tentative return to oil and gas – even coal. After a long silence, big asset managers are again talking about their fossil-fuel funds. That may sound like a trivial change, but it is a huge public relations U-turn since the start of the decade, when those same portfolio managers jetted from conference to conference talking almost exclusively about their green credentials. Money follows talk – and vice versa.

That said, the sector still is not the investment darling it once was. As a share of the S&P 500, energy companies account for a mere 2.95 per cent of the index market value, compared with more than 16 per cent in 2008, when oil peaked at nearly US$150 a barrel. That in part reflects the fact that technology valuations are sky-high; but it also indicates that oil companies are not nearly as valued as in the 1990s and early 2000s.

Still, die-hard fossil-fuel enthusiasts who had the industry to themselves for several years are fearful about what comes next: higher valuations and, over time, a loss of financial discipline. For now, lower oil and natural gas prices are keeping companies on their toes, with everyone from Chevron to Shell focusing on cutting costs. But in a cyclical business, it is only a matter of time before prices recover and companies do not feel the pressure anymore.

ESG was terrible for the fossil-fuel industry; but it was also great for investors brave enough to swim against the tide. BLOOMBERG