HomeBlogFinanceOil valuations: gushing cash flows are not being reinvested

Oil valuations: gushing cash flows are not being reinvested

The US-Saudi scuffle has boosted oil prices. Oil is hovering around $95 a barrel, not far off where it was a decade ago. European oil stocks, however, are pricing in a whole different world. Back then, the Euro Stoxx oil and gas index traded at 10 times forward earnings. It is now at five times — at least in part because fossil fuels are widely perceived as on their way out of the energy mix.

Oil companies read low valuations as a signal to reduce investments in all but the very best new oilfields. Indeed, their capital expenditure has fallen a third over the past decade, according to Goldman Sachs. Or, put another way, Bernstein has calculated that the 50 largest listed oil and gas companies have cut capex from 2.3 times depreciation a decade ago to less than depreciation today. Instead, they spend free cash flow on reducing debt and buying back stock.

That would be textbook energy transition — if the slack were being taken up by investments in renewable energy. But it is not — or at least nowhere near fast enough. Oil and gas groups are doing quite a lot in this space but that remains minor in the context of their traditional business. And while they are growing fast, renewable companies as yet lack the heft of oil and gas majors.

As a result, investment in primary energy supply and infrastructure fell from $2tn in 2014 to $1.5tn in 2021, says Goldman. Investments in renewables will grow significantly in coming years, but probably not nearly enough to make a difference.

Switching from one energy system to another — and doing it seamlessly — is clearly not an easy proposition.

There are a few conclusions to be drawn. The first is that energy supply may well remain tight, which would support oil and gas prices in the absence of a recession. The second is that these companies are likely to do rather better than their share valuations suggest. Finally, the energy transition needs a bigger push if it is going to fill the gap created by fossil fuels. Over time, high oil and gas prices will themselves provide some of the impetus, but not without imposing a significant drag on an already wheezing global economy.

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