Who Can Recover Royalty Money From A Bankrupt Oil Company

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Tobacco companies have far more pricing power than oil producers.
Photograph by Jeff J Mitchell/Getty Images

For years, tobacco companies were the clearest example of "sin stocks," businesses that make money by selling a harmful product. Oil companies didn't fall clearly into that category.

Warren Buffett, for instance, was willing to invest in oil long after he had renounced cigarette stocks. Investors stuck with the shares despite the damage burning fossil fuels does to the environment, not to mention catastrophic failures like the 1989 Exxon-Valdez oil spill in Alaska.

Growing awareness of climate change, however, has made oil stocks toxic to many investors. That has created two risks for the shares.

First, mutual-fund managers may simply decide not to invest in them, given the environmental consequences of fossil-fuel use, the strength of the ESG movement, and the companies' struggles to consistently produce positive cash flows.

At the same time. the growing renewable-energy sector is becoming a more important competitor, even though the economic impacts of electric cars and solar power are still dwarfed by combustion engines and gas-fueled power plants.

Regardless of whether investors think oil will soon go away as a critical source of energy, it is important to consider how the stocks will deal with the coming transitions toward a world with greater awareness of the risk of carbon emissions, and less dependence on fossil fuels. In a September research note, RBC analyst Biraj Borkhataria looked at the similarities and differences between the tobacco and oil industries—and what oil companies could learn from those other "sin stocks."

Tobacco is a much more concentrated industry than oil, with the top five companies controlling more than 80% of the market. Those companies have enormous pricing power, and have used that power, together with the addictive nature of their products, to make up for declining demand for cigarettes.

Oil companies, however, are dependent on market prices they can't control. Only Saudi Aramco, as the leading producer in OPEC, has any power to influence the price of oil, though even that is debatable.

Still, demand for oil continues to rise despite concerns that the fuel's days are numbered. That has given many oil executives confidence that their existing business models will hold up in the face of new regulations and potential limits on carbon emissions.

Borkhataria thinks that the two industries are different enough that it doesn't make sense for investors to use the exact same playbook. But oil companies can certainly learn some things from the experiences of Big Tobacco, he says.

For one thing, it does make sense for companies to start to pivot to alternatives, he argues. Philip Morris International (ticker: PMI) said as early as 2016 that it planned to move away from cigarettes. "We're going to lead a full-scale effort to ensure that smoke free products replace cigarettes," the company said in its annual report that year, Borkhataria noted.

Imperial Brands (IMB.UK) and British American Tobacco (BTI), however, appeared more reluctant to move away from their traditional models. "Combustible products remain at the core of our business and will continue to provide us with opportunities for growth," British American Tobacco wrote in its 2016 annual report.

Since then, Philip Morris stock has outperformed its two competitors, trading at a higher multiple of per-share profits even as its earnings have been similarly weak. Investors like Philip Morris's pivot to alternatives like its IQOS device—a heat-not-burn product that allows users to inhale a nicotine vapor.

For oil companies, the analyst says, it is time to start thinking about adding renewable energy to capital expenditure plans—and not just a nominal amount. Oil demand is likely to grow by 1% to 2% a year and natural-gas demand could grow 2% to 4% in the medium term, but many oil companies—including Exxon Mobil (XOM) and the Norwegian company Equinor AS A (EQNR)—are still spending money on projects that will likely increase their production by more than 5% per year.

Very few companies have committed to spend substantially on renewables, but that may be starting to change. Royal Dutch Shell (RDS.B), for instance, made a bigger commitment this year. (Barron's picked Royal Dutch as a top stock for 2020.)

"Shell's most recent Capital Markets Day marked the first time an integrated oil company has committed to shifting away from the traditional growth model and actively positioned itself towards carbon transition," Borkhataria wrote. "Investors welcomed this, despite a reduced returns and earnings outlook—similar to what we observed in the tobacco sector."

Borkhataria thinks oil companies shouldn't abandon capital expenditures on oil and gas projects. But they shouldn't sink more capital into large projects that are meant to increase production even more. Instead they should spend that money on buybacks and dividends, investments in renewable projects, or both.

They should also focus their capital expenditures on short-cycle projects that result in faster production. That would mean more money going to places like onshore shale basins that produce oil quickly, rather than to deepwater projects that can take several years to yield any crude, Borkhataria said.

Write to Avi Salzman at avi.salzman@barrons.com