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Why Oil Companies Can’t Replace Oil Profits With Renewable Profits | OilPrice.com

Last week we argued in Oilprice.com (“Can Renewables Become As Profitable As Oil and Gas?”, January 5, 2021) that oil companies could not maintain their expected levels of profitability by investing massively in renewable energy companies. The reason? A mismatch between business and financial risk in these very different industries.

In financial theory, there are two related concepts of risk that determine the level of expected investor return: business risk (the inherent operating risk of a going concern) and financial risk (the degree of leverage or debt managements utilize in the company’s capital structure). There are two key things to consider here. First, there is typically an inverse relationship between business and financial risk. Stated simply, the higher the operating risk of a business the less debt it can afford to carry. The reverse is also true. Inherently low risk businesses like regulated utilities can carry a significant amount of leverage.

The second point to make here in this regard is the role of management. No team of managers no matter how skilled can change the operating risks of the business. Operating risks are like DNA; they’re inherent in a business activity itself like drilling or mining. Debt levels on the other hand can be manipulated up or down subject to management discretion.

This has now become a problem for the oil industry. New investments in the renewables business have low business risk, are often regulated under long term contract and can be financed with considerable leverage. Oil exploration on the other hand is a relatively high business risk activity subject to market and political uncertainties and as a result typically employs far less debt on their corporate balance sheets.

Renewable energy companies are low risk businesses. And in business a lower risk usually means a lower return for investors. Or to put it another way, investors in wind turbines in west Texas accept a lower return than those say financing new oil exploration in Alaska. Consequently oil companies entering the renewable energy business must compete with existing builders, some state sponsored, who accept a lower return on investment than what an oil executive would regard as acceptable. And since capital is the biggest cost in the renewables business, those who accept the lowest return are usually successful in garnering the most new business. Related: UAE Oil Major Turns To Hydrogen

The most recent cost of capital estimates out of NYU’s Stern School of Business reinforce this point. We show three indicators of the problem. First, look at the cost of equity capital, that is, what shareholders expect to earn or they will not invest. Then consider the overall cost of capital. Note that oil investors want to earn almost three percentage points more than utility type investors for both equity capital and total capital (see Figure 1).

Figure 1. Estimated cost of equity and of capital (Jan. 2021)

Cost of capital is a tricky measure, so let us consider the equity risk premium—in this case, how much higher of a return equity investors need over what they would earn if they bought the bonds of the company instead. As demonstrated by Figure 2, oil investors want an extra 390 basis points, while utility investors expect only about 230 basis points. Not only are oil bonds riskier (pay higher interest rates) but oil equity demands a higher premium over the bond coupon rate to invest. (See Figure 2.)

Figure 2. Cost of equity vs cost of debt (Jan 2021)

To put these numbers in perspective, bringing down oil company returns (based on 2017-2019 data) to utility levels would reduce industry net income by one third. But oil company managements thus far have only committed a small portion of their future capital expenditures into low risk, lower returns renewables investments. Related: Saudi Output Cut Boosts Demand For Russia’s Urals Crude

Royal Dutch Shell has been hauled into court to force the company…

Read More: Why Oil Companies Can’t Replace Oil Profits With Renewable Profits | OilPrice.com

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