The oil and gas energy transition: is cutting costs enough?

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espite an increasing shift towards renewable power in many parts of the world, oil remains the dominant form of global energy. Figures from energy consultant Enerdata show that oil accounted for 31% of the world’s total production of power sources in 2019, the most of any power source, and with global annual oil production increasing by around a billion tonnes between 1990 and 2019 , there is little evidence to suggest that oil will be going away any time soon.

Yet this does not mean that this well-established industry is economically efficient, or even ultimately profitable. A report published in Oil and Gas 360 found that the price required to sell a barrel of oil to break even, based on the cost of producing that barrel, could be as high as $194.6 per barrel in Iran, by far the largest break-even price in the world. This is the most extreme example of an increasingly expenditure-intensive industry, where current oil prices mean that up to 45% of global oil production could be unprofitable.

In response, many of the world’s leading oil majors have announced cost-cutting measures, concluding that with demand unlikely to dry up any time soon, improvements to operational efficiency are the best way to maximise profit margins. Yet cost-cutting alone is unlikely to save an oil industry that is struggling to maintain lucrative profit margins, despite its continued raw output. Figures from the US Energy Information Administration predict that the net oil export revenues of the OPEC is set to fall from $711bn in 2017 to $580bn in 2020.

This disconnect between growing production and falling revenue has raised questions as to the best ways to ensure the financial and environmental viability of the sector.

This impetus to cut operating costs is clear across the oil and gas industry. In March, amid the first waves of the Covid-19 pandemic, Total announced a number of dramatic cost-cutting moves, including capex cuts of $3bn and improving existing operational efficiency to cut $800m from its opex, more than double the cuts originally planned this year.

Even beyond the short-term financial uncertainty triggered by the pandemic, these majors have been looking to streamline their operations. In May, Chevron announced plans to cut up to 15% of its global workforce, around 6,000 of its employees not based at petrol stations, as it tried to cut opex by $1bn for the year. Similarly, Shell has aimed to cut its opex by 40% this year, in addition to capex cost reductions  of some $5bn and cuts to opex of $4bn that were already announced, in the immediate aftermath of the Covid-19 pandemic.

This presence of both short-term and long-term motivation for the cuts suggests that these changes run deep, forming part of a wider cost-cutting initiative across the sector, rather than existing as stopgap responses to the pandemic, that could see long-term financial changes for the oil and gas industry.

“Cutting costs wherever possible has been a major priority for the oil and gas sector this year as price weakness is impacting their financial standings,” explains Daniel Rogers, an oil and gas analyst at GlobalData. “In order to navigate the current market volatility and ensure profitability at these levels, cuts are being made to boost operational efficiencies and reduce expenses.”

These cuts are motivated not just by the fear of losing out on future profitability, but by recent financial struggles from all three majors. Chevron’s weakening finances are perhaps the most dramatic, with its net income across its operations collapsing from $14.9bn in 2018 to $2.8bn in 2019, but this is a pattern seen across the sector. Shell’s income, for instance, fell from $35.6bn to $25.4bn over this period, and while Total’s income has remained relatively stable over the last three years, its total expenditures are just over $5bn less than its income from operations, a much finer profit margin than could be considered comfortable.

While the bottom line is among these majors’ key concerns, there are additional motivations behind this shift, not least the increasing importance of environmental stewardship in these companies’ activities. While it could be argued that large-scale oil production is inherently at odds with environmental protection, simply shutting down oil majors is neither a feasible, nor necessarily beneficial, response to an increasingly unstable environment. Many oil majors are, in fact, embracing steady changes to gradually improve their environmental performance.

“Environmental concerns have led to a shift in the traditional business model of a typical oil and gas company, thereby forcing some international oil and gas companies to transition into international energy companies,” says Rogers, highlighting a subtle shift in the large-scale role and fundamental purpose of these organisations.

“The energy transition is going to be a financial burden for the industry as significant investment will be necessary to better optimise operational efficiencies, create solutions to minimise environmental footprint and invest in lower carbon projects and technology,” Rogers continues. “Most of the oil majors are now setting a path towards a reduced environmental footprint from their operations and products, by setting net-zero emissions targets well into the future and reporting emissions data on an annual basis through sustainability reporting.”

This emphasis on reporting environmentally-aligned information also suggests a softer criteria motivating these majors, namely that being proactive on environmental concerns is one thing, but being seen to be being proactive on these issues is quite another. A company can enjoy a significant boost to its reputation and public perception should they actively engage with better environmental practices, with many in the fossil fuels sector looking to follow the example of Ørsted, which has successfully transitioned from an oil and gas major to one of the world’s leading renewable energy companies.

“The level of pressure will depend on where the company operates and the nature of its stakeholders,” says Rogers of this external pressure, yet he noted that this influence may not be enough by itself to spark dramatic change in the sector. Instead, he suggests that a convergence of environmental concerns, awareness of public perception, and financial viability is integral to this inspiring this kind of change.

“The likes of Ørsted have proven the ability to make that shift away from a traditional oil and gas business, which was likely driven largely by political and social pressures but also accelerated by the fact that renewable energy has become cost competitive against hydrocarbons,” Rogers says. “For a larger entity such as Shell or BP, making that shift will be much more challenging given the global footprint of their operations and their value being almost entirely driven by their oil and gas business.”

Yet these majors could face significant challenges ahead as they try to make these cuts, not least because of the sheer scales of their operations. In 2019, Shell, Total, and Chevron collectively owned assets worth close to a billion dollars, and their latest employment figures show that between them, the companies employ around 233,000 people. As such, any changes to financial or operational practices are likely to have far-reaching ramifications.

“[A] challenge will be employee retention, as the workforce continues to face uncertainty with regards to job security and employee satisfaction,” says Rogers on this point. “Having to compensate for severance packages will be a short-term implication for reducing the workforce.”

Furthermore, the diversity in the number and characteristics of the countries and companies that produce significant volumes of oil means that changes in policies affecting one actor may not necessarily affect another.

“For companies that are under continued political and stakeholder pressure to put environmental, social, and governance concerns at the forefront of their operations, will be required to maintain a balance between financial performance and environmental sustainability; this would include mainly the major European oil and gas producers,” Rogers explains. “Whereas companies that are not under such pressure to prioritise environmental impacts, such as national oil companies of developing nations, will likely put more effort into securing energy supply for their respective nations and maintaining strong financial standings.”

This dichotomy between typically Western oil and gas producers under pressure to cut costs and improve environmental performance, versus producers such as members of OPEC that are motivated by financial interest to a greater extent, is echoed in the cost of producing a barrel of oil in these regions. In Canada, the cost of producing a barrel of oil is $11.56, while in the US this figure can range from $5.15 to $5.85 for non-shale and shale oil respectively. Meanwhile, Iran has a per barrel production cost of just $1.94.

Yet as shown earlier, Iran has the highest break even point for its oil production, despite its significantly low production costs, suggesting that minimising costs alone may not be sufficient to generate long-term financial stability. A more holistic response, which considers the distinct yet connected factors of financial interest and environmental responsibility, could be more effective. Yet considering the range of oil production settings and economies around the world, it may be impossible to apply a single solution or type of solution to a range of companies and countries.