This blog originally appeared on the IEEFA website

By Tom Sanzillo, Kathy Hipple and Clark Williams-Derry

Invest in the future or return cash to shareholders?

The oil and gas industry confronts a host of challenges that would have been inconceivable a decade ago: weak cash flows, meager profits, slumping stock values, volatile revenues, unreliable demand growth, and rising competition from renewables, to name just a few.

The industry now faces a quandary. Should companies continue to invest in new drilling projects, doubling down on their increasingly risky bets on fossil fuels? Or should they ignore long-term production growth and simply return cash to investors?

Both choices are fraught with peril.

When companies spend money in hopes of increasing production somewhere down the road, they alienate investors desperate for short-term returns. But when they increase payouts to shareholders without investing in the future, they signal that they’re a shrinking industry.

In 2008, the energy sector commanded roughly 16% of total Standard and Poor’s 500 market capitalization. Today, that figure has fallen to roughly 6%. In 1980, seven of the top 10 companies in the index were oil companies. Today, only ExxonMobil is in the top 10 (ranking tenth).

For much of the past century, Wall Street gauged an energy company’s value by the size of its oil and gas reserves. Oil and gas companies responded in lockstep, spending cash on exploration and drilling in order to boost their reserves.

After years of subpar results, however, as companies spent more on drilling than they realized from oil and gas sales, investors are now urging oil and gas companies to prioritize profits over production growth. Today, Wall Street punishes and gas companies that fail to exercise “capital discipline,” while rewarding companies that hand cash back to investors.

Nonetheless, some companies are once again finding reasons to boost capital expenditures. After three years of cutbacks and freezes, oil and gas capex will rise to $500 billion in 2018, by some estimates.

This trend intensifies financial pressures in a cash-strapped industry. Oil projects, particularly high-capital projects such as Canada’s oil sands and deep-water drilling, expose companies to severe long-term risks.

Prices will have to top $100 barrel, with a reliable upward trajectory, for company CEO’s to take their thumbs off cost controls. Natural gas investments may look more financially sustainable than oil because of projected growth in global demand. But natural gas is now a low-margin business. Pursuing growth in gas output exemplifies the production-over-profits strategy that has sapped the sector’s financial vitality.

Low and volatile prices make it more difficult for the industry to justify capital expenditures for drilling, pipelines, mining, and other infrastructure. And it becomes especially hard to defend new capital projects when the industry is still writing off prior failures.

MAKING CAPEX DECISIONS IS A DAUNTING TASK, in no small part because exploring for oil and gas is often a multi-decade process, fraught with risks that range from geological to geo-political. Multi-billion-dollar costs must be weighed against benefits that may never accrue. Making matters worse, price and demand forecasts are subject to unpredictable shifts in technology, policy, and economic growth.

Mistakes by oil and gas companies can have outsize consequences, due to the massive scale of investments. 

Consider ExxonMobil, which as of 2016, was the only oil major that had not yet taken any significant write-downs of its assets, despite the sharp drop in oil prices in 2014. Exxon finally took significant impairments after the SEC began making inquiries: