"He who has the gold," said the stunted king from the cartoon The Wizard of Id, "makes the rules."
A growing number of institutional investors are heeding the king of Id's sarcastic "golden rule." But unlike Brant and Hart's irreverent cartoon, the real-life outcome of shareholder activism – the influence of the guys with the gold – on big energy companies, may not be so funny. Today's new rules are such that companies, guided by their vocal shareholders, are progressively shunning big, risky oil and gas projects that take forever to build.
Because of the lengthy lag between input capital and output hydrocarbons, the full impact of today's corporate decisions will show up a few years from now, probably in the form of higher commodity prices. In the meantime, the accelerating trend is for capital in the energy business to shift away from megaprojects in favour of those that are smaller, shorter cycle and more certain. Canada's conventional upstream business (that which excludes oil sands) is already a beneficiary of this tilt in capital allocation.
It's not a secret that big investors are exerting more influence on how a company's capital budget should be spent. Executives leading publicly traded, independent oil and gas companies with global reach are all listening to the same bluesy riff from their large shareholders: "Don't spend my gold on your risky projects any more/You're making my returns look sore/Profits, not production should be on your fastest track/Else give my money back."
Last week we saw an overt example of these dissonant lyrics in action.
New York hedge fund investor Jana Partners urged Apache Corp. to pull out of big, uncertain international projects and focus the corporate purse on the known unknowns of U.S. shale oil. Jana's golden rule directive included Apache's share in Chevron Corp.'s Kitimat LNG consortium, which was given the proverbial X.
But the hasty stroke of Apache's black felt pen was less an indictment of B.C.'s LNG opportunity than a reflection of the reasons driving Id's golden rule. In most oil and gas domains around the world, exploration and development risk have gone up significantly over the past couple of years without a proportionate rise in investment returns.
It's hard to argue with the golden rule in today's vulnerable energy complex. Why would any rational investor want their capital directed to countries laced with corruption, sanctions, rebel insurgency, civil war, or authoritarian leaders that can expropriate assets with a quick throne speech?
Uncertainty has gone up even in benign, free-market economies with stable politics and rule of law. For example, project delays and cost overruns have ravaged returns in Australia. And we know that multibillion-dollar oil and gas projects – LNG, oil sands, pipelines – with cost uncertainty and regulatory ambiguity can be readily found in Canada too. No doubt these factors influenced Apache's directive to exit Kitimat LNG.
Certainty commands a premium in today's oil and gas environment. Publicly traded, independent oil and gas companies will increasingly be corralled by their investors to recycle cash flow into safer capital projects. Safe is a relative notion, but implies less perceived risk, greater returns, faster cycle time and smaller quanta of investment – in other words, faster return on money with less to lose.
U.S. and Canadian resource plays – hydraulically fractured light oil and shale gas – are natural receptors for relatively safer capital in today's uncertain world. Good upstream plays in places like Alberta and Texas can be developed at a fraction of the cost of global megaprojects, offering superior returns in a friendly back yard.
Smaller, shorter duration projects with high returns are already a growing fad for shareholders. The golden rule is favourable to the upstream segment of Canada's conventional oil and gas business (that which excludes the oil sands, pipelines and LNG facilities). Year to date equity markets for oil and gas juniors – a group focused on small conventional projects – are up about 34 per cent (see Figure 1).
With few other options for investment, megaprojects have been the flavour of the decade in the energy business. Big multi-year projects will still attract capital on the global stage, but new competition from smaller North American projects is pushing the hurdle to attract that type of gold higher. Ultimately, commodity prices will have to rise to attract risk-seeking gold again.
Peter Tertzakian is chief energy economist at ARC Financial Corp. in Calgary and the author of two best-selling books, A Thousand Barrels a Second and The End of Energy Obesity.
Peter Tertzakian