Oil income available to governments and investors shrinks in the SDS, but does not disappear

Billion dollars (2018)

1 500

1000

500

2019 2040

A key financial issue facing the industry is whether the lower prices and production volumes of the SDS lead to a collapse in the income available from oil and gas, with potential implications for investments, returns and taxes.

In the SDS, there is a significant decline in net income from oil and gas in 2040 compared with today. This income also needs to cover the cost of any new upstream investment, with the remainder being available for governments and investors.

The fall in income relative to 2019 does not necessarily portend an investment crunch, as the requirement for upstream investment is significantly lower than today. Nevertheless, the pool of income available to share between governments and investors is around 40% lower in 2040.

This smaller pot of income would have impacts on the financial and industrial landscape for oil. Smaller independent companies may be challenged to stay in business, take on riskier new projects or face consolidation pressures from industry leaders. Average company size may rise. Shareholders are likely to prioritise total returns, but also increasingly focus on diversification and sustainability strategies (see discussion below). In the absence of credible moves to boost income (and returns) from newer energy areas, the industry may continue to face pressure to maintain a robust dividend yield and continuous share buybacks. The use of debt finance may also be constrained by the prospect of declining or more uncertain revenues.

Income allocation between investors and governments is subject to complex dynamics as companies compete for resources and governments compete for investment. In energy transitions, some resource-rich countries may find themselves under pressure to bring in investors or face the possibility that national resources remain

undeveloped forever, especially in a world where US shale output maintains a strong competitive presence in the market. The reviews of upstream fiscal and contractual terms prompted by the price downturn in 2014-15 could be a sign of things to come.

From an industry perspective, this analysis suggests that companies may be able to continue financing investment in core oil and gas areas to meet lower demand in the SDS, while maintaining an acceptable return for investors. However, a number of uncertainties may arise, such as market volatility or disruptive changes to policies or investor sentiment, which could result in adverse impacts on internal rates of return (IRRs).

The bottom line is that, as energy transitions progress, oil and eventually natural gas become smaller and more competitive spaces in which to operate. Reliance by companies on these investment opportunities and reliance by governments on the associated revenues become steadily more risky strategies. Both of these factors speak to the importance of diversification.

ROIC

WACC

Typical energy project IRRs

Indicative enhancement of renewables IRRs

(onshore wind example)

20%

16%

12%

8%

4%