Energy Transition Resilience: Fortress balance sheet
Preparing for substantive and virtue signaling risks during the transition
This week I will expand on the idea of the critical importance of having a fortress balance sheet, the second tenet of the energy transition resilience framework I introduced in last week's ESG 2.0 post (here). A fortress balance sheet goes hand-in-hand with the first tenet, generating competitive full-cycle returns on capital employed (ROCE) that I have discussed extensively in previous posts (here, here, and here).
The key goals of being resilient to what I expect will be at least a multi-decade (century long?) energy transition era are:
Regaining investor relevance (i.e., energy recovers to >5% of the S&P 500 from 3% today and a recent low of 2%);
Being able to withstand and potentially take advantage of extreme commodity price volatility;
Being nimble to whatever demand trends ultimately emerge for crude oil and natural gas;
Meeting the world's energy needs with as a minimal of an environmental and carbon footprint as possible;
Regaining/retaining a societal license to operate (i.e., global youth stop thinking the oil industry is evil).
The key issues/risks companies should strive to navigate:
Substantive
Can a company generate at least break-even GAAP (i.e., not-adjusted for write-offs) net income at cycle troughs?
Can a (large-/mid-cap) company generate supply growth that broadly matches, or perhaps slightly exceeds, whatever global crude oil or natural gas demand growth turns out to be?
Can a company meet net zero objectives for Scope 1 and 2 while also substantially eliminating methane flaring/venting/leaks on a time scale consistent with broader society (presumably 2050 but may be a different year, sooner or later)?
Virtue signaling
Can a company survive if US/European capital markets access is taken away, or, perhaps more likely, will only be available if increasingly stringent carbon reduction objectives are met?
Can a company survive broader divestment initiatives, no matter how ill-advised?
Can a company survive and thrive as different political regimes change rhetoric and rules every few years?
It remains my view that ensuring energy transition resilience has the potential to lead to a healthier, more sustainable oil & gas industry over the long run. It is going to be the best part of the ESG movement. I share the frustration many of you have with the virtue signaling side of ESG and climate change initiatives. But if the world is to finish the job on eliminating energy poverty while also ensuring adequate, affordable, secure energy supply exists for everyone, the importance of a sustainably profitable, healthy, and societally engaged oil & gas industry has perhaps never been higher.
The oil & gas industry at some point over the last decade lost its right to exist solely on its own terms. Poor profitability, weak balance sheets, and a combination of delay tactics and remaining on its back-foot when it came to helping address environmental and climate challenges has sunk the sector to equity investor irrelevance. It’s up to everyone associated with the industry to flip the script and return oil & gas back to relevance.
Energy transition resilience framework
In my view, the key characteristics of an oil & gas company that will prove resilient to the energy transition are as follows:
Double-digit full cycle returns on capital (best-in-class is 15%-20%+) and at least break-even at trough of cycle (best-in-class is 8% at the trough).
Fortress balance sheet.
Net zero Scope 1 and 2 emissions by 2050 and verifiable intermediate goals for the next 5 and 10 years to go along with overall HSE leadership.
Technology leader, including for finding and developing oil & gas and in regards to emissions reduction technologies.
Attract, develop, and retain a globally diverse talent pool.
Fortress balance sheet: There is no such thing as too much cash or balance sheet capacity
The idea of having a strong balance sheet has always been important, though not always adhered to, given what has now been 40+ years of volatile spot commodity pricing since the emergence of commodity trading markets in the 1980s (prior to the creation of NYMEX trading, some combination of OPEC, the Seven Sisters, the Texas Railroad Commission, Standard Oil or similar entities effectively set or heavily influenced the price of crude oil and refined products). The emerging energy transition in my view warrants a ratcheting up of what is considered a strong balance sheet.
A fortress balance sheet has related offensive and defensive characteristics:
Can your company survive and thrive in a downturn or unexpected evolution in the energy transition, when others may be less well prepared?
Do you have enough balance sheet capacity to make major “all-cash” investments at the trough of a deep cycle like we saw in 2020?
Are you able to maintain through cycle CAPEX programs, if otherwise desired, assuming an extended period of below-normal commodity prices?
Can you continue to sustain and ideally grow dividends to shareholders through the inevitable sharp swings in commodity prices?
Do you have a combination of balance sheet capacity and cash generation in the event capital market access doesn’t exist for your company?
There is not a single oil company I am aware of that can answer “yes” to all of those questions if we look at the 2015-2020 period. It is true that the severity and duration of that downturn I don’t expect to be repeated in the 2020s. However, I also know that “stuff happens” and a combination of policy randomness, ESG & climate virtue signaling, and both normal and energy transition-driven oil and gas supply/demand uncertainty I believe make a fortress balance sheet a must.
S&P 500 leaders have more cash than debt
For much of my career, the discussion has centered around an optimal net debt/capitalization ratio. To keep a complex issue simple, I would say that a 25%-35% net deb/cap ratio or lower was considered to be healthy by most investors. I suspect we will move to a world where net debt for the best-in-class will be closer to zero, and perhaps even more cash than debt (i.e., negative net debt).
It is my personal view that there is no such thing as "too strong" of a balance sheet or having too much cash on hand. I appreciate investors will fear that too much cash is a forerunner of bad acquisitions or other over-spending, but it is not clear to me that fear is born out as it simply doesn't exist for well-run companies in my recollection (yes, there have been plenty of bad acquisitions, but the only one I can remember by a company with competitive ROCE and an ultra strong balance sheet was XTO Energy by ExxonMobil; former clients/competitors can send me other examples I may have forgotten).
If you look at the Top 20 companies in the S&P 500, excluding the two financials, JP Morgan and Bank of America, as well as ExxonMobil (#18) and Chevron (#23), cash plus marketable securities exceeds debt by 5% (see Exhibit). Are these top companies reasonable role models? Heck yes they are. If oil & gas wants to regain investor relevance, it is going to have to compete with the best of the best. No one cares if Exxon's balance sheet is better or worse than Alcoa or US Steel or Macy's or General Motors or any number of other marginal companies.
How realistic is a capital markets “ban” for oil & gas? "Creeping Death" is the risk
I suspect there is nothing quite like energy crisis conditions in rich regions (US, Europe) to move global elites to saner ground on the inevitably massive role fossil fuels will continue to play in providing our energy needs for many, many decades to come. I would place the odds of a complete ban on fossil fuel investment or capital markets access in the United States as close to zero, lets just say by 2030; beyond that, who knows. For Europe, the odds are higher, though Euro Majors have already "lost the plot" and bent the knee to the climate pharaohs so probably a moot point over there.
For the US and Canadian oil & gas industry, I think the phrase "Creeping Death" best describes how companies should think about capital market access. Continued capital market access could well become more closely tied to increasingly stringent net zero objectives. We can only pray that Scope 1 and 2 prevail as the acceptable standard; there is no logic to Scope 3 as currently defined which I will elaborate on in a future post. The goal is to stay ahead—and ideally well ahead—of the grim reaper. The “lamb’s blood painted door” for oil & gas, I believe, is the combination of competitive full cycle ROCE paired with a fortress balance sheet—“I shall pass!”
Resist Street noise about sub-optimal debt/cap levels
Typically as an upcycle progresses, Street analysts and short-term investors start demanding greater stock buybacks and cash returns. It's understandable and as a rule preferable to top-of-cycle acquisitions (off the top of my head I can't think of even one top-of-cycle deal that worked out, but maybe there was one). Going forward, the combination of higher commodity price volatility and uncertainty about the pace and path of the energy transition I believe warrants holding more cash-on-hand than previously seemed prudent.
In my view, investors tend to be more comfortable with sizable cash balances and negative net debt when there is confidence that a management team has a demonstrated track record of value creation and being responsible investors of capital. That is not where the oil & gas sector is today, but is where it is striving.
Double digit full-cycle ROCE
A fortress balance sheet is consistent with superior returns on capital, free cash flow, sustained capital discipline, and an asset base that allows all of that to perpetuate. It’s not about not spending; it's about spending wisely, which is easier declared than done.
I know this one is a shocker as I have only written three ROCE deep dives (here, here, and here), but I believe competitive oil & gas companies will have double-digit full-cycle ROCE (defined as an average over 5 and 10 years); best-in-class companies will generate 15%-20%+ full-cycle ROCE. At the trough of the cycle, competitive companies will at least break-even, with an 8% trough-of-cycle ROCE for best-in-class.
And as I have articulated in some venues, if there is a different corporate-level profitability metric you prefer, have at it. Just don't make up metrics that don't ultimately tie back to bottom line earnings, cash flow, free cash flow, and organic balance sheet health.
On a personal note...
January 17 is a US holiday to celebrate the life and legacy of Martin Luther King, Jr. As a child of Indian immigrants, it turns out I was blessed with the good fortune of generally benefiting from positive prejudgments—it was assumed by teachers and other parents that I was smart, nice, honest, and non-threatening, to name a few. My parents came to this country with two suitcases and $25 in 1961 to get advanced degrees in Physics (dad) and Psychology (mom) from Cornell University. I retired at 45 years old as a partner of Goldman Sachs. I am living proof that the American Dream is very much alive and well. May God Bless America and my parents for emigrating here.
What is also clear is that many Black Americans do not enjoy the same benefit of the doubt that I do, in fact, often, just the opposite. I know I could have done better when I was in charge to have taken more time to better understand the life experiences of various employees from less advantaged backgrounds. To be clear, it’s not about overlooking a real or perceived lack of merit, which is the excuse usually given. It is about recognizing the differences in life experiences and hurdles one may have needed to overcome, acknowledging those realities, and trying to help those that don’t benefit from the positive prejudices that I do.
Disclaimer
I certify that these are my personal, strongly held views at the time of this post. My views are my own and not attributable to any affiliation, past or present. This is not an investment newsletter and there is no financial advice explicitly or implicitly provided here. My views can and will change in the future as warranted by updated analyses and developments. Some of my comments are made in jest for entertainment purposes; I sincerely mean no offense to anyone that takes issue.
Regards,
Arjun
Appendix A: Definitions and Clarifications
The balance sheet exhibit data is downloaded from S&P Capital IQ and is as of the third calendar quarter of 2021. Note, I have never directly covered the non-energy names discussed and there are likely nuances to their financials that I do not appreciate and have not incorporated. I believe my analysis of the non-energy S&P 500 leaders is reasonable from a “big picture” perspective, but should not be relied on at the micro level.
As a measure of balance sheet health, my preference is to look at net debt (total debt less cash-on-hand including marketable securities and other short-term, liquid investments). In an environment where capital market access is not guaranteed, it is likely prudent to also look at absolute levels of cash-on-hand. In this note, I have simplified balance sheet health to look at net debt and net debt/capitalization (with capitalization defined as net debt plus shareholder’s equity). Clearly, financial health encompasses a broader array of metrics and measures, which I have not discussed in order to improve read-ability and minimize the length of this post.
As usual, my analysis of the energy industry is geared toward the perspective of larger and medium sized companies. For smaller companies, both public and private, there is likely a much wider range of potential financial strategies that would be appropriate on a case by case basis.
In using the word “ban” regarding capital markets access, I am not necessarily referring to public policy or regulatory restrictions per se. Rather, it is a softer though still insidious shutting out that could occur if the acceptability of oil & gas follows coal. There are many reasons coal is generally off limits for many institutional investors in the United States and Europe, not the least of which is it is no longer a major business and in recent years had struggled with profitability and viable companies to invest in. Oil & gas is still a major sector (even at its diminished size) and I believe profitability will return. However, you can already see the seeds being sown in Europe to have oil & gas join coal on the “can’t do” list. US and Canadian companies need to be prepared for this risk.
Appendix B: Super-Spiked energy transition playlist
This third addition to the Super-Spiked energy transition playlist is dedicated to the two subscribers I definitively know will appreciate the Creeping Death reference, which immediately struck me as the framing for today’s fortress balance sheet topic. I went to the show 17 days after this one (link below) at Brendan Byrne Arena by which time vocalist/guitarist James Hetfield had broken his arm (he just sang at our show). What has long been known as Metallica’s “Passover” song is now my energy transition rallying cry and the third entrant to the Super-Spiked energy transition playlist. While the video and audio quality are consistent with a 1986-era camcorder, there is no beating the energy and intensity of a young band on the rise. I didn’t fully realize until watching this some 36 years later that I had in fact seen Cliff Burton (bass player) in person before he passed later that year in a tragic bus accident, may he rest in peace. Previous playlist tracks are listed below and were introduced here and here.
Super-Spiked energy transition playlist: