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With an unknown future energy mix, how do you shift your investments?

If interest rates go up and industry uncertainties increase, can utilities and oil and gas companies turn themselves into more compelling investment propositions? Matt Rennie and Andy Brogan examine the challenges.

 

 

 

The way things are …

Capital is not scarce right now. Balance sheets are robust, bank debt is cheap and historic performance suggests energy is a mostly safe and reliable investment.

Most energy projects have long lives. They are favored by pension funds and other investors interested in long-term and stable returns. But ask which energy sources will be the main fuel source 30 years from now, and you will not get a definitive answer. How, then, can investors back energy projects and technologies that have uncertain returns and lifespans?

For energy companies to diversify into low-carbon and renewable technologies and spread the risks of their portfolios; for them to innovate and discover new energy sources; for them to transition from large and lumbering to lean and flexible, they need serious amounts of risk-friendly financing. And for that, investors need clarity.

… in power and utilities

Lack of certainty should point to dwindling investment. However, the low-interest-rate environment continues to be on the side of the power and utilities industry. Compared with other return-generating investments, network assets seem a low-risk punt. So, demand is growing, pushing up valuations, generating more demand. The grid, investment-wise, is also perceived as a safe place. It is a means by which new technologies will come to market. Or is it?

As soon as interest rates head north of 4-5%, prepare for network assets to take a backseat as investors seek higher returns elsewhere. Moreover, a drop in capital expenditure to support the network peak once new technologies come online, will see valuations fall. Lower valuations, on top of a higher interest-rate environment, will translate into reduced appetite for network assets and harder-to-come-by capital for investment.

… in oil and gas

Increased price volatility in the oil market and changing structures in the gas markets have reduced producers’ certainty when sanctioning projects. This increases reliance on balance sheet debt and public bonds to fund the industries’ extensive capital requirements.

It is not a problem in lower-risk projects and those where the sponsor has adequate balance sheet strength, but it is opening up a funding gap in higher-risk projects conducted by smaller market players. As most innovation happens at this end of the spectrum, we are facing a long-term challenge.

Even among larger players, the flight from risk is leading to smaller projects that minimize capital concentration. In turn, the move towards faster and less complex projects is compressing time between project approval and completion. These days, given a choice of spending US$15bn and five years developing an asset that produces 300mbd and US$6bn, or three years developing one that produces 120mbd, most companies will opt for the latter.

As in power and utilities, there is extensive use of cheap debt. It is used to finance low-risk, low-volatility components of the value chain, such as midstream pipes and storage infrastructure. If, or when monetary policy tightens, it will present a real risk of a funding gap.

“The challenge is not so much about getting access to finance but about energy companies turning themselves into more compelling investment propositions in a higher interest-rate world.” Andy Brogan, EY Global Oil and Gas Transactions Leader

Exercises in becoming more investor-friendly

The challenge is not so much about getting access to finance but about energy companies turning themselves into more compelling investment propositions in a higher interest-rate world.

So, utilities, as well as oil and gas companies, are working hard to identify where they can accelerate returns or move to lower break-even points to keep capital flowing. They are pursuing full-on implementation of digital technologies and are rejigging their portfolio mix to respond more quickly to shifts in the market.

They are also taking a serious look at their assets to work out which might be integral to energy supply going forward. They might divest or acquire to ramp up capabilities, while recognizing that newer assets take time to generate returns at scale.

Increasingly, an optimized portfolio is spread across assets and jurisdictions to reduce risk, and may include:

  • Conventional large-scale assets that break even at a low level to generate returns through the price cycle, but take anything from three to ten years to develop; and

  • Flexible assets, such as solar, with reduced development timeframes that can be ramped up and down in response to energy price points, but break even at a higher level.

“Scale is pretty expensive to build from scratch. Any sort of organization that has existing connectivity with customers and has scale, is a target for mergers and acquisitions.” Matt Rennie, EY Global Power and Utilities Transactions Leader

Survival tactics

Across the industry, the talk is of agility, not scale. Yet success in the energy retail market depends on scale. You cannot innovate products and services without a platform with wide customer reach. Though incumbents are not especially nimble, they have invested in building scale and are increasingly mindful of the need to firm up the customer experience with new and better technologies.

New market entrants will have to secure finance, and “back-end” their offerings through the acquisition of scale operators. Scale is relatively expensive to build from scratch. Any sort of organization that has existing connectivity with customers and has scale, is a target for mergers and acquisitions.

In fact, big digital retailers could be very good disrupters. They have the experience and customer connectivity to supply energy and bill monthly, with no interruption to delivery or service. On the oil and gas side, cloud-based mobility solutions are compatible with their existing skill sets too.

Of course, the big pressures in oil and gas derive from lower commodity prices and the longevity of the hydrocarbon business model. Both influence the attractiveness of the sectors to equity investors. Their participation is essential if the industry is to fund higher risk/reward initiatives to drive its growth and repositioning across the value chain.

Coping with lower commodity prices means a relentless focus on cost and productivity, and faster uptake of digital technologies. Long-term viability drives multiple strategies, many of which are associated with a move closer to the customer. In this context, companies are seeking growth in petrochemicals and gas applications (including re-entering the electricity market). They are also re-examining their retail estates for ways to deliver alternative forms of energy. Many, of course, are looking at their energy mix and making inroads into solar, wind and biofuels.

What the future holds

The outlook is a bit of a mixed bag for energy companies and their investors right now. Interest rates are low; access to capital shows no real signs of tightening. However, as rates rise and competitive exuberance wears off, or a pension fund over invests and gets its finger burned, the market will react and low-risk, stable-return asset values must fall.

From around 2025, the combination of rising interest rates and elimination of the network peak could see equity become a more important part of the funding mix for energy companies. This challenges large utilities and oil and gas companies to set out compelling cases to equity investors as they seek to attract the funds that will finance their transformation.

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How will you shape your future in energy?

  • New technologies are changing the value chain, providing increased stability or spurring competition and volatility. Discover our energy insights and details on Energy Reimagined, EY’s Energy Summit.