The temptation of diversification: “We learn from history that we do not learn from history.”
Georg Hegel, philosopher (Lectures on the Philosophy of History 1832)
This is not the first time that the oil sector has experimented with diversification. During the 1980s, when oil prices were very low, companies owned a variety of businesses, including mining, pet food, typewriter manufacturing etc. These mostly did not go well or end well, which shareholders do – or ought to – remember. Managements at the time justified them “as applying our skills in related businesses” or “moving along the value chain” just as they are today with the plethora of new energy/low carbon energy/technology related businesses in which they are investing. Again, this is an exercise in capital allocation, risk management and communication and requires discipline and a ruthlessly honest review process to avoid a repetition of the sector’s past mistakes.
The attraction is clear: if the core businesses are not growing as fast as they have done in the past, or are even in decline, there will be excess capital – and management may believe that they should re-invest this in other growth, businesses. This can ignore the fact that there are both internal and external markets for capital. Oil and gas companies may not be the best owners or managers of the new growth businesses, just as the management of any business may not be the best team to be in charge of a very different business. Shareholders often have the opportunity to invest in such businesses, should they wish to, as standalone shares, run by specialists – unless an oil and gas company owns a business not available elsewhere. If the internal and external markets for capital become too out of line, the market will react accordingly, from de-rating the shares to, in more extreme cases, the company ending up being taken over. Shareholders may be tolerant of diversification while the scale is small, but they will want to understand the guiding principles and financial metrics being used by management before the scale of such businesses grows.
Oil and gas companies may not be the best owners or managers of the new growth business
There has been a 30 year trend in stock markets to move away from conglomeration in all sectors. This has been driven by the trend for higher valuations of pure play companies, the desire of shareholders to create their own portfolios of businesses and to change them quickly and at low cost. Management in many sectors have embraced this change. Results have often improved when a business is spun out: management is freed from a conglomerate framework and the remaining, more cohesive company has also often performed better. Pure play companies have often traded at higher valuations than conglomerates, even where the businesses are quite closely related to the core value chain of the business. This continues with a variety of companies in a wide range of sectors selling or spinning off parts of their businesses, and in some cases, potential bidders or activist investors encouraging such action. Even within the oil sector, the virtues of upstream/downstream integration have been questioned, though this has been largely resisted by managements (an exception being Conoco / Phillips 66 in the US). There are also questions about how well conventional oil companies can run US shale businesses, given their differences.
Questions that shareholders will want managements to ask themselves as they consider investing in new businesses include:
- What risks are we willing to take, to what scale and for how long? It is important to have a powerful and honest review process.
- Is this a business that we understand and can run as well as or better than a stand-alone specialist company? These businesses are either early stage (renewables) or undergoing great change (power utilities) and may commoditise, reducing long term returns.
- When assessing this investment, do we understand how to risk it correctly versus our other projects? These businesses are at very early stages in their lifecycle and the potential scale, scope and long-term returns are far from clear. They are also very different from each other and from the standard models used by oil companies to assess projects for their core businesses.
- Are we considering the timing? Should we get in early or wait until there is greater clarity?
- Is there a cultural fit with the company, or can it be run separately enough not to limit or damage it? This is a huge challenge for large, hierarchical companies trying to invest in early stage growth businesses. The experience of large-cap pharma with biotech companies has been instructive here: it is all too easy to smother an acquisition and lose all the key people.
- Do we have the discipline to assess each opportunity honestly and not justify poor acquisitions or businesses because “they gain us access to other areas of the value chain”?
- Can this business ever scale enough to be material to a group our size? It is not yet clear what the natural size of many of the new energy businesses will be and whether there are real advantages to their being international. If companies end up running a portfolio of medium size businesses, is this something they can do well? Is it very different from their current business model?
- Do we have a clear idea not just of what will constitute success, but also failure, given our targets for the group as a whole? Success: a good business that we can run well and scale up. Failure: a terrible business that we are not good at, and will not scale up, but there is a whole range of outcomes in between. Are we always comparing these opportunities with returning capital to shareholders so that they can make their own investment decisions?
- Are we communicating clearly with our shareholders so that they understand what we are doing and why? Are we providing adequate information, in a comparable format from year-to-year so that they can follow and evaluate our progress? Other than Petrobras, there is no separate segmental financial information available for the new energies businesses – and narrative only gets a shareholder so far.
- Are we being realistic about how significant these businesses can be to us? This is important both in terms of internal management time and external communication. Even quite small businesses can take up a disproportionate amount of management time and energy.
There will be new entrants we have not even thought of yet, started by people currently still at school.
Could it be “different this time”?
There certainly are and will be many opportunities in the future low carbon economy and some oil and gas companies may be successful in some of them. Yet the future is so uncertain and the opportunities so diverse that there cannot be one single, or simple, answer. Companies will have different capabilities, make different choices and have different outcomes.
The question of timing is often raised. There can be a feeling of urgency: “something must be done now or this opportunity could be gone forever”, but in many cases it may be better to invest later with more clarity. It may seem as though valuations would inevitably be higher but, to some extent, it is a question of how well you price risk in a very early stage business and indeed how good you will be as an incubator for a small business versus being an owner of a larger, more mature business. Again, there is no one correct answer, but these issues are important to consider.
The sector has already invested in a wide selection of businesses. These range from biofuels to generation assets (wind, solar) to customer facing (B2B energy and fuel sales, consumer energy retailing, EV charging points) to services (energy trading in various power markets, firm power offerings, behind the meter and connected home energy management). In each case, they will be facing developing competitive landscapes and the risk of disruptive technologies. Although, at least, the oil and gas companies do not have the burden of legacy assets facing the traditional utilities, the power utility sector is changing very fast and it is not at all clear where the most attractive parts of the value chain will be in the future. Technology is changing rapidly and some businesses will commoditise. There will be new entrants we have not even thought of yet, started by people currently still at school.
Companies have bought stakes in businesses, or bought outright, while some are investing in venture capital type vehicles to get exposure and learn. Only time will tell what works and, provided that the questions above are addressed well, companies can learn what they can succeed at and, just as importantly, what they cannot.
Shareholders can make significant returns investing in a declining business, as long as it is run as such – and will respect you for such a strategy
Managements in general, not just in the oil and gas sector, want to manage – and the growth and scale of their businesses are important to them. Some shareholders, many of whom already hold International Oil Company (IOC) shares for the dividend income, see great attractions in a declining business, run tightly for cash, returning capital to shareholders and providing attractive total returns. The shares can outperform and managements can be highly regarded and remunerated even if the business is declining. (This worked for many years in the tobacco sector where companies chose to cost cut, consolidate and return capital rather than initially diversifying). It should not therefore be regarded as a strategy of defeat.
We may be years away from this being an end-game strategy, but if a company is generating more cash than it needs for its core businesses and can’t find attractive alternative investments (given all the caveats above) then returning capital is the correct response. After all, the stock market exists to allocate capital across economies.