By Ben Dell, Kimmeridge
The US Exploration & Production (E&P) industry is in a state of flux, even as commodity prices reach triple digits. After a decade of low equity returns capital has fled the space, multiples have compressed and operators have been left to live within cashflow. The industry’s response up until very recently has been to hunker down, change little about the business model and hope for a short-term cyclical recovery.
What happened to the industry over the past decade was more than a cyclical low, it was a response to years of poor capital allocation choices made with a mindset of growth for growth’s sake, coupled with poor alignment between shareholders and management. Worse still is how the industry has buried its head in the sand while the rest of the world evolved its stance on emissions, and continued to justify flaring and loose operating practices.
To many, the energy transition is a shift away from oil and gas. But what if oil and gas had no net carbon footprint? Would there be a reason to not use it? We believe the energy transition is a transition to a net-zero future, but one that will continue to have hydrocarbons in it, and one where E&P can be disciplined, profitable and relevant. Achieving this will not be easy. It will take dedication, commitment and transparency. But there is already an established template for execution.
The new model
The new E&P business paradigm, which Kimmeridge was an early framer and strong proponent of, is built around three core pillars, namely: establishing a profitable business model that returns free cashflow to investors; instituting a corporate governance model that is aligned with investor objectives and ties executive compensation to the health of the business; and achieving net-zero on Scope 1 and 2 emissions (direct and indirect emissions, respectively, from any owned asset).
This last lever is uniquely important today, where there is somewhat of a misunderstanding about how O&G companies can or cannot exist and produce responsibly going forward.
The fact is, the world is still reliant on fossil fuels and we don’t yet have the infrastructure to support a rapid transition away from that energy source. Instead, we need to use the tools we already have to get to net-zero – today.
For example, Civitas Resources was formed from the merger of three legacy O&G producers in the DJ Basin, and is today the state of Colorado’s first carbon neutral E&P. In order to reach and maintain its status as a net-zero operator, Civitas utilises a suite of best practices. These include retrofitting legacy facilities and pneumatic devices, utilising tankless or closed-loop production facilities, plugging inactive or legacy vertical wells, internally incentivising reduced emissions and much more. At the literal ground level, Civitas has designed operations to run largely on the city’s electric grid, reducing the fumes otherwise emitted by diesel fuel truck runs.
Civitas also offsets residual Scope 1 emissions using certified offsets sourced from the four largest and most credible offset registries, in addition to offsetting Scope 2 emissions through Green-e certified renewable energy credits.
Engagement versus divestment
Understanding the challenges of decarbonisation, and engaging to reduce emissions, are key to effectuating change. Running away and encouraging larger companies to divest assets to low-quality, privately run E&Ps that can operate in the shadows is certainly not the answer. If investors select this path, poor habits will prevail, shareholder value will be destroyed, the environment will suffer and nobody will win.
While it was once a rarity to see E&P companies measuring their carbon emissions, now more are committing to sustainability and reporting on these metrics. Despite the progress, it remains to be seen if this trend will continue as commodity prices rise and the incentive for companies to act responsibly moves with it.
As long as the world demands oil and gas from companies, the sector will produce it. But we believe that delivering net-zero Scope 1 and 2 oil and gas production is both achievable and logical no matter where we are in the commodity price cycle.
It is the responsibility of investors to stay engaged and ensure that E&P companies are producing oil and gas as efficiently, safely and in as environmentally friendly a manner as possible.
Ben Dell is a managing partner and founder of Kimmeridge, an energy private equity firm focused on investing in low-cost oil and gas assets in the US. This article first appeared in affiliate publication PE Hub