Pure Crude and Mixed Messages: Capital Allocation in the Energy Industry

March 15, 2022
By Sydney Isaacs

If you had to guess which administration’s Energy Secretary had said to oil and gas companies, “We have to responsibly increase short-term supply where we can right now,” you could be forgiven if you had Trump or Bush, rather than Biden, at the top of your list.

The war in Ukraine has dramatically reshaped the U.S. domestic energy agenda in just a short few weeks, temporarily uniting the Democratic administration and the U.S. oil and gas sector around the need for energy from fossil fuels, at least in the near term. This would shore up domestic energy supplies and reduce voters’ pain at the gas pump — both administration priorities.

But industry participants must walk a fine line, balancing political interest in increased production, and potentially even a national security imperative, with shareholder demands for capital discipline. The choices that energy companies make related to capital allocation will be closely scrutinized by both shareholders and politicians and even the broader public. In light of this, communicating how they are evaluating and prioritizing a range of complex factors should be a more prominent and detailed component of companies’ messaging across communications mediums in the current environment.

Complicating the capital allocation decision are existing supply chain and labor constraints that limit operational flexibility. Soaring but volatile energy commodity prices may be tempting for producers, but there is little clarity as to how long pricing will remain at those levels. Furthermore, ramping oil and gas production takes both time and money, so without assurances that prices can be sustained, it will be hard to make the case for increased CapEx.

In fact, at the recent CERAWeek conference, some oil industry executives already commented that the increase in commodity prices alone won’t lead them to alter CapEx budgets because it’s not certain how long prices will remain elevated and because capital discipline is in their DNA.

For the last few years, the clear capital allocation priorities for many in the upstream energy sector have been focused on deleveraging and returning value to shareholders via buybacks and dividends. In fact, many shareholders have been vocal about promoting this approach and punishing the companies that put too much emphasis on production growth. As a result, CapEx budgets have remained conservative, and the habit of keeping production and expense low has become ingrained.

With sudden new demands resulting from the war in Ukraine, however, all eyes will be on capital allocation as companies prepare to announce their 1Q results. Amid these diverse and divergent interests, oil and gas producers must carefully consider and communicate not just their capital priorities but also the factors that are driving capital allocation decisions, and how those factors are evaluated relative to one another. Companies should also strive to make clear these considerations and their thought processes to both shareholders and stakeholders such as elected officials and regulators.

In addition, energy companies must be clear to communicate that they are not disproportionately benefiting from this crisis, which the Biden administration has already been quick to warn the industry about. In wartime, even the ordinary operation of commodity businesses can be misconstrued as gouging or profiteering. There is the opportunity for the industry to clearly communicate how increased cash flows can be reinvested to accelerate the energy transition. Steering cash flows towards prudent investments in clean technologies can be an area of common ground between energy companies, politicians and shareholders and should be prominent in the discussion about capital allocation decisions.

With CapEx budgets just recently announced and attentions focused on the industry’s role in the response to Russia’s aggressions in Ukraine, this is a time to share more color as to how companies are assessing sometimes competing priorities and stakeholder interests and navigating the complex energy politics in Washington. If the industry doesn’t shape this narrative itself, multiple stakeholders have new incentives to try to control this critical story.