A change in strategy can reignite a company’s profit growth. Or, it can lead to large opportunity costs. In my opinion, Centrica’s decision to refocus on its customer-facing supply business at the expense of its Oil & Gas operations falls into the latter category.
I understand why the company felt it needed to rebalance its business model and reduce its financial risk. It had been seeking to become a global leader within the Oil & Gas production sector, which may have been an overly ambitious target that would have meant major investment over a long period.
However, I also believe the lower oil price may have influenced the company’s thinking. While things did get worse for the oil price following Centrica’s strategic review in July 2015, today the outlook for the industry is much brighter than it was a couple of years ago. Therefore, I think Centrica may have been better off sticking with its original strategy, rather than responding to what may prove to be a temporarily low oil price.
Strategy change
Centrica’s strategy is relatively simple. It is seeking to reduce its exposure to the Oil & Gas industry through asset disposals, many of which have already taken place. It will instead seek to become a more robust business which is able to leverage its competitive advantage in the energy supply and energy services markets.
This should improve the company’s cash flow, with capital expenditure within its Oil & Gas assets expected to fall to between £400 million and £600 million per annum. This is down from 2014’s figure of over £1 billion, although investment in technology could offset reductions in free cash flow made from lower investment in its Oil & Gas operations.
Alongside this, the company is seeking to cut costs, mostly through a reduction in the size of its workforce of around 10%. By 2020 it expects to deliver annualised cost savings of £750 million. A fall in net debt of 27% in 2016 marks another step forward for the business, with a general trend towards derisking being a central theme of its present strategy.
Oil price potential
When Centrica decided to shift its focus away from Oil & Gas exploration in July 2015, the outlook for the oil price was extremely negative. It had fallen from $110 per barrel in 2014 to less than $50 per barrel by mid-2015. At the time, therefore, the decision to refocus on its customer-facing assets seemed like a shrewd move. It was moving away from a declining sector and pivoting towards one where it seemed to have a competitive advantage.
Today, however, the decision seems less impressive. Although the outlook for the oil price remains uncertain, reduced production from OPEC and non-OPEC producers should allow the oil supply surplus to reduce over the next few months. There is even the potential for an extension to the supply cut, which could push the oil price higher over the medium term. Therefore, the prospects for the sector appear to be much brighter than they were two years ago, when Centrica decided to transition away from its Oil & Gas activities.
The prospects for the sector appear to be much brighter than they were two years ago, when Centrica decided to transition away from its Oil & Gas activities.
On the one hand, reduced investment in the Oil & Gas sector may create a more stable business model which is better able to develop a competitive advantage through its brands, products and services. However, I believe it also means Centrica could miss out on what may prove to be a relatively prosperous period for the Oil & Gas sector.
Other majors in that industry have been able to cut exploration and investment spend, but still maintain their presence and market share. Companies focusing on the long term have even made acquisitions when oil was trading at its lowest price. I believe a strategy which followed those paths could have created a more profitable Centrica in the long run.
Political risks
While Centrica’s energy supply operations are not solely focused on the UK, it remains a key market for the business. With inflation rising to 2.3% in February, the outlook for UK consumers is highly uncertain. Another 30+ basis points increase and inflation will be higher than wage growth, which could mean a return to a cost of living ‘crisis’. This was a key part of UK politics during the financial crisis and was seen as a key vote winner at the time.
Another era of real-terms falls in disposable incomes could now be ahead. This may not only be the case in the UK, but also in North America, which is another key region for Centrica’s supply operations. Donald Trump’s fiscal plan includes lower taxes and higher spending. The end result may prove to be rising inflation. Should this beat wage growth, the US and UK may see political pressure on energy companies increase as energy prices become a popular focus for politicians seeking to capitalise on hardship for consumers.
While this may not necessarily lead to lower profitability in the short run, it may cause regulatory change which is designed to make energy more affordable. Therefore, in my opinion, Centrica’s decision to focus on its customer-facing supply business should not be seen as being without risk.
Outlook
While I feel Centrica’s strategy could deliver rising profitability in future years, I also believe it will miss out on an improving Oil & Gas sector. That’s not only with regards to profit growth potential, but also the prospect of improving investor sentiment in the sector. In fact, Centrica already seems to have missed out on this, since its share price has fallen 5% in the last year. At the same time, Oil & Gas companies such as Shell and BP have gained around 30% in the last year.
I also think the risks from focusing on energy supply may be higher than expected. Political risk could be significant if the trend of rising inflation continues. This could put pressure on household incomes if it beats wage growth, leading to energy companies potentially becoming increasingly unpopular – particularly if they raise prices due to an increasingly buoyant oil price.
Therefore, although a change in strategy can sometimes be beneficial to a company’s financial and share price performance, I believe Centrica’s current strategy may not be the best means of delivering a higher share price for its investors. Higher earnings may be ahead for the company, but they could have been even more appealing given a greater focus on its Oil & Gas operations.