The long and the short of it
Dec 3, 2015
Speech given by Simon Henry, Chief Financial Officer at Shell, at the Financial Times – Deloitte Extractive Industries Executive Dinner Debate, London, UK, on December 3, 2015.
In this speech, Simon Henry describes long and short-term cycles facing the energy industry, including political, investment and media cycles. To address these, he argues that international energy companies like Shell must: deliver current projects exceptionally well (on time and on budget); have the courage to make decisions in the good times and the bad; and test and tweak business strategies constantly.
Ladies and gentlemen, good evening. It’s a pleasure to be here with you.
“In all things there is a law of cycles.” So said Tacitus, a senator and historian of the Roman Empire. Although I feel like it some mornings, I wasn’t around 2,000 years ago. Nonetheless, I’d wager these words are as true today as they were then.
As CFO of Shell, cycles affect me on a daily basis. Part of my job is about weighing up long-term investments in oil and gas projects, while also taking into account the shorter-term needs of investors.
With that in mind, I’d like to spend a few minutes running through cycles facing the energy industry. I’ll then look at different approaches international energy companies should take to address them.
There are two long-term cycles which stand out for me.
The first is the cyclical nature of supply and demand in the global energy system. The last two centuries have shown that this system takes a long time to change.
The supply cycle was marked by upgrading to better energy sources from biomass such as wood and peat to the use of coal to fire the industrial revolution in the nineteenth century. Then the use of oil, and later natural gas, to help power everything from homes to cars in the twentieth century.
Then there’s the demand cycle which will take place this century; driven not only by technology and innovation that unlocks better energy sources, but also the need to reduce impact on the environment. Multiple sources of energy and fuels – from oil and gas to solar and wind, hydrogen and biofuels – will be needed to meet growing demand for energy, while also cutting emissions.
The second long-term cycle I want to flag is the time is takes for major energy projects to develop.
In areas where there’s been no historic exploration activity, it can take more than a decade from analysing seismic images to starting production.
Large renewables projects also require similar planning, financing, designing and constructing that can take years.
Now on to the short-term cycles the energy industry must consider.
The first one worth mentioning is the political cycle. At best, this looks ahead to the next election. This has an impact on businesses, as the regulatory or tax environments may shift from government to government. Last week’s announcement by the UK government to pull funding from a competition to develop new CCS technology is a classic example of how cyclical political decisions have a direct impact on companies.
Another cycle I want to highlight is the investment cycle. In the current climate – with the exception of long-term funds – investors’ patience is limited when it comes to waiting for returns. Their interest in companies like Shell is driven predominantly by the results we report on a quarter by quarter basis.
Then there’s the 24-hour media cycle. Before the major newspapers had online editions I remember Shell reporting its results, and then waiting a day to read reactions. But as Chris [Adams, Energy Editor, Financial Times] and others here from the FT can attest, these days our results are released at 7am, and by lunchtime it’s old news. This means any shift in attitude from investors and commentators is reported immediately and reflected in our share price.
Sticking with the short-term a moment longer, the final point I want to make is that companies like Shell generally fund their own capital investments in major projects, rather than going to the market to raise capital. This is in contrast to companies like Facebook and Amazon. This puts short-term cyclical pressure on our balance sheet whenever we want to make a big investment in a new project.
So that’s the lay of the land.
There are a number of things international energy companies like Shell can do to address these cycles, and the challenges and potential misalignment associated with them.
Delivering current projects
First of all, it’s critical for companies to focus on delivering current projects exceptionally well; on time and on budget.
This may seem – as my kids would say – a ‘no brainer’. But it’s important on two fronts. One, it addresses the short-term investor and media cycles. It sustains trust that Shell manages investors’ capital well, over the cycle. And two, it will result in operational cash flow which can, among other things, be used to fund long-term investments.
As for how these projects will be delivered well, it comes down to innovation and collaboration. Two well-worn words. But for good reason. On hearing them again and again, energy companies mustn’t become immune to their importance. They must be a constant mantra inside every employee’s head.
Courage in convictions
Second, I want to stress that major energy companies must have the courage to make decisions throughout the oil price cycle. This is the same for alternatives as for oil and gas.
Sometimes, short-term cycles put pressure on companies not to make big investments when the price of oil is low. But given the length of time projects take from inception to first production, companies must make investments in the good times, as well as the bad.
There are no guarantees in this business. We crunch the numbers. We do all the necessary due diligence. We look at how technologies and markets are changing. We look at how competitive it is against our portfolio of assets. Then, and only then, do we make a call on whether or not to invest.
Sometimes it doesn’t work out for us, especially in the high risk exploration part of our business. Look at our recent decision to cease exploration off the coast of Alaska.
Other times it does. Look at the Athabasca Oil Sands project in Canada. Shell invested in this project in 1999 when the price of oil was less than $15 a barrel. But jump forward a few years to 2003, when production was in full swing, and the price of oil averaged $30 a barrel that year. And then to 2010 with $100 a barrel.
Test and tweak
The third point I want to stress is the importance of testing and tweaking our business strategies throughout the different cycles. This is essential in any effort to be a major player in the unfolding energy transition.
It’s interesting to reflect on the approaches governments, in particular China and Germany, are taking.
China, for example, is adopting an empirical mind-set when it comes to its long-term energy strategy. There is a willingness to test new ideas. To be ambitious.
The liberalisation of its energy market is a good example. China has taken a phased approach.
This includes the establishment of a regional trading hub and the potential creation of an independent national pipeline firm. By liberalising the market in phases, China can keep testing and tweaking, so that the outcome is exactly what they’re after.
In Germany, the ambition of an 80-95% reduction in greenhouse gas emissions by 2050 is laudable. But the near-term policy measures adopted to get there has meant an increase in the use of coal and emissions. This highlights the need to be mindful of the short term, as well as keeping an eye on the long-term when developing effective policy.
But I’d also like to reflect on a relatively unsung aspect of Germany’s energiewende. They’ve thrown themselves into tackling the global challenge of providing more energy with less carbon dioxide.
After several years into the plan, they’re now starting to test and tweak what works and what doesn’t, with a specific focus on cost and affordability.
Some ideas, like wind, are working well. Others, like solar, are patchy. But then the progress they have made is now helping to stimulate solar in other countries.
Shell has taken on this way of thinking with carbon capture and storage. In the short-term investor cycle, there’s little recognition of the benefits of CCS.
But looking at the long term, we see a big benefit to those wanting to decarbonise their economies. The IPCC has trumpeted it as the single most cost-effective technology to get us onto a low-CO2 pathway.
Simply put, renewables will be essential in meeting future energy demand. But hydrocarbons will also be needed, as some sectors are harder to de-carbonise than others. CCS can play a key role in a future where more energy is provided with fewer emissions. A future we want to be part of.
It’s for these reasons that we’re making investments like the Quest CCS project in Alberta, Canada. We are publicly sharing information on the design and processes to help bring down costs of future projects and encourage the widespread adoption of CCS.
So there you have it. There are a whole host of cycles, each of which present different challenges and opportunities.
The thought I kept coming back to when reflecting on these cycles is the importance of not over reacting, but also of not underreacting.
Are the short-term cycles important? Absolutely. But they shouldn’t distract from the long-term intent.
The overarching challenge for international energy companies is to find a balance between addressing short-term concerns, while remaining focused on the future.
That, as they say, is the long and the short of it.