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Oil majors are finding the right business model for renewables

Oil majors like to boast about investing in cleaner forms of energy, but advertising campaigns are a lot easier to produce, than implementing changes in their business models. The trouble is the oil and gas industry generates great returns. For those with access to enough start-up capital to lease the land, find the oil, drill the well, and deliver it to market, can result in big profits, until the well runs dry.

Although they, are likely to be smaller as regulators insist on the industry fully paying for the cost of decommissioning of such energy projects. However, clean energy investment are different, according to Wood Mackenzie, an energy data analysis and consulting firm. Oil exploration generates an 8 percent to 15 percent internal rate of return (IRR), which is a measure of the premium a business idea pays over lower-risk investments.

In fact, US onshore oil production averages a 33 percent IRR, observes a Wood Mackenzie report ‘How oil & gas Majors can scale in renewables’. By comparison, a wind project in a developed country generates around 7 percent IRR, while solar earns just 5 percent. But, renewables projects in developing markets such as South Africa, Morocco or Brazil can generate higher IRRs, but only about 9 percent.

The point is most large-scale renewable projects to date have been backed by contracts with a large proportion of fixed revenue,” Wood Mackenzie reports. “Investments with fixed-price contracts are low risk, but offer low returns.” By comparison, everything about an oil and gas well is risky, from finding a deposit to operating the rig safely.

But, wind and sunlight are easy to find and measure, the equipment is not dangerous to use, and for now, the 20-year cash flow is predictable. But, the steady phase-out of feed-in tariffs for wind and solar energy is ending in many countries, and this is likely to reduce the investment returns for long-term contracts.

As a result, we are seeing an increasing number of subsidy-free projects being planned, proposed, and developed worldwide. In fact, 15 photovoltaic projects underway from Italy to the U.K. that aren’t relying on subsidies to make a profit, according to Bloomberg NEF, which anticipates many more to come. Nevertheless, such projects face greater risks, because of fluctuations in the wholesale power markets. Not surprisingly, there are increasing risks for investors. Although, such higher risks will bring higher rates of return, expanding opportunities for oil and gas companies.

Slow adoption

There are reasons the oil majors have been slow to enter the renewables sector, these include:

  • For a start, a matter of competition, there are many experts and experienced competitors involved in grid-scale projects of 1 GW. Often, such projects are bankable, low risk, and have low technical complexity is full of many competitors.
    • However, there are few competitors in the market for mega projects of around 10 GW. For entrants interested in such mega developments, you need to have one at least one of a few things: large balance sheets, tolerance for aboveground risk, existing relationships, or technical knowledge, so not surprising that oil majors like BP, Shell and Equinor are taking an active interest in such mega renewables projects.
  • Renewables developments tend to be smaller in scale and cost less than oil and gas projects. Typically, oil majors are used to investing in big scale projects costing billions of dollars or Euros. For instance:
    • Equinor’s new Johan Castberg offshore oil and gas field in Norway’s North Sea. Equinor will invest some $5.9 billion in this offshore project and expects cash flows to total $33 billion over 20 years.
    • US LNG exporter Cheniere has estimated the cost of building its first five LNG liquefaction-processing trains at Sabine, with a production capacity of 27.0 mtpa of LNG is expected to cost between $17.5 billion and $18.5 billion. Analysts at Cowen & Co said in a note that Cheniere should generate about $4 billion in discretionary cash flow through 2021.
  • However, there are few renewables projects that cost more than $1 billion or more. Typically, most wind and solar projects cost less than $500 million, so often of little interest for oil majors, used to managing projects costing $1 billion dollar or more. However, we are starting to see a few renewables projects at the scale and costings that Oil companies are used to. Here are a few examples:
    • The $1billion 20 GW Walney Extension, in the Irish Sea,
    • The $9billion 580 MW Ouarzazate Solar Power Station in southern Morocco, is currently the world’s largest operation solar farm.
    • The Asian Renewable Energy Hub, this joint $20 billion solar and wind project, now plans to export 6 GW to South East Asia and 5 GW to large energy users such as mines and LNG liquefaction export terminals in the Pilbara region of Western Australia.
  • Once, enough energy storage and transmission capacity is developed to server renewables projects , the viability of such investments will further improve. Since there will be sufficient power available to meet peak demands over the day by domestic and industrial consumers, plus increasing usage by electric vehicles.

The dash to electric

As vehicle users make the dash away from petrol and diesel-fuelled vehicles, there will be a growing demand for electric cars, taxis, etc. Some big oil companies like Shell, Eni and Gazprom, see a future for heavy transport like Ships, trucks and busses.

But other big oil companies, like BP, Total and Shell, also see a future in renewables combined with energy storage. For instance, Shell sees a future where some power for electric cars will come from renewables, whilst the rest will come from gas-powered generators. It looks like Shell is hedging its bets on the future.

One thing is clear, making a move into cleaner energy, although pleasing many an environmentalist, is unlikely to please shareholders as they face the prospect of lower earnings. So, not surprising oil majors see a future where they are developing both their gas and renewables portfolios.

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