Oil companies are increasingly investing in low-carbon technologies that have the potential to disrupt their core and end-markets. Their principal hydrocarbons business remains profitable; but to build long-term value, they need to think about a future where, for example, vehicles are powered by renewable energy and are driver and owner free.
Oil companies are creating optionality through maintaining a core focus on oil and gas, while investing a threshold amount in new alternative energy businesses – including renewables, which often need additional capital to grow. The question is: how do they create value from investing in early-stage companies? Major oil corporations are used to managing large and long-term capital-intensive projects, but engaging with start-ups needs a different set of skills and carries less familiar risks.
In this week blog we’ll look at how the oil sector is responding to new challenges and think about the broader cross-sector challenge of transforming non-traditional investments into long-term value.
“The automobile is only a novelty — a fad.”President of Michigan Savings Bank, to Henry Ford’s lawyer advising him not to invest…1903…
The changing balance of power
Oil companies are responding to the Paris Agreement – and the need to embrace alternative energy sources – by extending their business model along the low-carbon value chain into areas like batteries and renewables. The oil peak may be some time away. The oil sector remains profitable. Oil companies may only be seeing disruption of their core business model and end markets at relatively low levels for now. But the impetus for change is growing – not least from investors – and many oil companies are responding by setting targets for low or carbon-free revenues in the coming decades.
The area with the most at stake is transport, given that more than half of world’s oil is used in the transport of people and goods and just over a quarter is used in passenger vehicles. According to Bloomberg NEF, cumulative electric vehicle (EV) sales passed four million in 2018. That might only be 0.4% of total vehicles world-wide, but that doesn’t take into account the growing steepness of the EV S-curve. It took five years to sell the first million electric cars, one and a half years to sell two million and just six months to reach 4 million. In China, EVs account for 4% of all vehicle sales, up 175% in 2018.
Moreover, whilst BP estimated in 2018 that EV numbers will reach 300m by 2040 – or 15% of the total global car fleet, it also forecast that EVs will account for 30% of all passenger car transportation, as measured by distance travelled. This is because it expects so many electric vehicles to be shared vehicles.
A multiplicity of options and outcomes has encouraged oil companies to spread their investments across a broad spectrum of low and zero-carbon technologies and infrastructure. In the last few years the major oil companies (particularly in Europe) have invested in renewables, formed alliances to invest in batteries; acquired EV charging networks and infrastructure manufacturers; and bought shares in ride sharing companies and apps that predict taxi demand; and even launched car-sharing services.
But the big question remains how successful these oil companies will be in creating value from these investments. Purchasing fully-fledged ‘disruptive’ assets is expensive and can limit the investment capacity of the firm. Buying earlier in the process allows companies to buy a wider range of smaller start-ups, but this presents fundamental questions and unfamiliar challenges to most major corporations – not just oil companies.
The most fundamental question for companies is ‘how will we realise value?’, and that leads to the second question of ‘what is the investment model that enables us to access that value?’ The simple choices for creating value are to:
- Create a new profit centre around the investment
- Combine the investment into an existing profit centre
As oil companies shift more investment into start-ups to seed their future growth, then options (2) and (3) become much more important.
Oil companies are used to risk-sharing investment models designed around capital intensive assets, often requiring political partnerships and market access. Start-ups and deliberatively disruptive investments require a different approach and raise different questions. How important it is to maintain control of day-to-day activities and keep exclusive access to generated intellectual property (IP)? Will a JV partner bring additional skills? Will full integration stifle innovation and be less attractive to the management and workforce. Where most of the value will lie? How much infrastructure and incubation will the asset need? Is there a corporate governance risk, and how do we manage it?
The CVC approach
In response, companies are increasingly using their own corporate venture capital (CVC) and creating corporate venture funds to hold investments and find a balance between parent company control and start-up innovation. Corporate venture funds allow the business to cover several bases via smaller investments. In return, the portfolio business gains access to the parent company’s capital, expertise, connections and branding. This model also allows the business to develop outside of the parent organisation, which can help preserve an innovative culture and perhaps retain staff that wouldn’t want to be integrated within a large corporation.
There isn’t a standard CVC model. Directly owned and internally dedicated funds have less exit pressure than independent VC companies, which need to meet investor expectations. They also allow companies greater say over investments to ensure that they’re aligned with their strategic objectives. But they obviously require greater commitment and carry greater risk. The corporate investor needs to decide if they bring in industry or venture capital expertise; set lines of responsibility; decide how much they will actively collaborate with portfolio companies; and how they will ultimately realise value.
The oil sector has previously used the CVC model for E&P technologies, but in 2017, investment in core upstream technologies fell below 20% of investment activity, according to IHS Markit. Activity has also shifted from digital technology (decreasing from 43% of investments in the first half of 2017 to 18% in the first half of 2018) to clean energy (increasing from 38% of investments in the first half of 2017 to 65% in the first half of 2018)
As companies have become more experienced, we have seen the progression from 1st Generation CVC models, largely strategic in nature and directly owned, to 2nd Generation, largely financial in nature, and now 3rd Generation, also financial, with much more active management of the ecosystem. These models are aiming to create a connected ecosystem that benefits from external collaboration, skills and financing, and also enable value creation through new profit centres and value chains as part of the company.
Whatever model investment companies use, success takes considerable effort. Alignment with parent company strategy and cross-fertilisation is inherently very hard. The parent business needs to have a culture that will allow them to absorb new ideas and technologies.
Within corporate venture funds, 3rd Generation models are aiming to break the mould, and to enable traditional oil companies to grow new businesses faster than before while creating both option value and real value for shareholders as they increase their investments in lower carbon energy and enabling technologies. For those that can make it work, it should enable the company to be more outward looking and move faster, but it requires a strong combination of investment expertise, entrepreneurial leadership, financial management, and integration expertise to move ahead of the market.
Edited by Kirsten Tompkins