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Big Oil’s Bet on Natural Gas Is a Slow Burn

Oil companies are betting on natural gas as the fuel of the future—and working hard to ensure new projects deliver profits of the future.

Last week, Royal Dutch Shell PLC announced a liquefied natural gas project in Canada that will cost $14 billion to build, while Exxon Mobil Corp. and partners are expected to approve a multibillion-dollar LNG project in Mozambique in 2019. That is a similar timeline to Russia's roughly $20 billion Arctic LNG-2 project, which is part-owned by France's Total SA.

Natural-gas projects historically have delivered lower returns than big oil projects, and as a result companies and shareholders have prioritized oil developments. That's something the companies are working hard to change.

Still, according to Edinburgh, Scotland-based consultancy Wood Mackenzie, the weighted average internal rate of return for liquefied natural gas projects currently in the pipeline is about 13%. That compares with 20% for deep water projects and 51% for unconventional oil developments like shale.

"The problem for oil companies is that gas is much more difficult to make profitable," said Eirik Wærness, chief economist at Norwegian oil company Equinor ASA, formerly known as Statoil.

The case for gas also becomes more difficult, at least in the short term, when oil prices are high as they are again today, though oil companies invest on a long-term horizon.

Yet big oil has little choice but to double down on gas. Companies have discovered fewer large new oil deposits than natural gas opportunities over the past decade. And governments, including China and many in Europe, are seeking to reduce pollution by burning cleaner fuels for transport and electricity. A new natural-gas power plant emits around half as much carbon dioxide as a new coal or fuel-oil plant.

Rising global demand also makes a compelling case for natural-gas investment. Oil consumption is expected to rise by just 0.5% a year out to 2040, according to Wood Mackenzie, a substantial slowdown from previous decades. Some forecasts anticipate demand will stop growing altogether within the next decade.

Natural gas consumption, though, is expected to rise to 24% of the world's energy mix by 2040, from 22% in 2016, according to the International Energy Agency. LNG's share of that market is set to rise to almost 40% in 2023, from around a third in 2017, the IEA forecast.

"It's all a balancing act," said Brian Youngberg, senior energy analyst at brokerage Edward Jones. "At the end of the day, oil is the most profitable product they produce, but demand is going to slow so you need to start managing that transition."

At the same time, oil companies are eyeing efforts to curb global warming that could make lower-carbon natural gas more competitive. Policies like a substantial price on carbon "moves the dial on gas," Mr. Wærness said.

By 2025, both Shell and BP PLC will be producing more gas than oil. French oil giant Total SA's production is already a near 50-50 split. Exxon Mobil Corp. is also planning significant new investments in LNG. The companies are selling the shift as a smart strategic bet on a growing market.

"The good news is that the natural gas market will continue to grow, and this explains why we are aggressive, offensive and expanding," Total CEO Patrick Pouyanné told investors last month. "On the contrary, the oil market will stabilize and even decline."

Investors have embraced the strategy, with some reservations. While big gas projects generate lower returns, they are profitable and provide much more stable long-term cash flow than most oil developments -- very attractive characteristics for shareholders who want to know their dividends are secure. And internal rate of return is just one way to gauge attractiveness. Many big gas projects offer additional opportunities for profit-generation through trading and business integration.

The natural-gas projects provide "very stable and consistent cash flow and this is something oil-and-gas companies have never really had, and what has made them so cyclical," said Richard Hulf, a manager of the Global Energy Fund at Artemis Fund Managers.

Companies are continuing to make significant oil investments, providing a balance to higher risk, higher reward projects that many investors like.

Yet the dash for gas highlights broader risks for the sector in an age of lower-carbon energy and an eventual shift away from fossil fuels altogether to more renewable energy.

"The pivot to gas the industry is engaging in will over time probably mean the industry is pursuing a dramatically smaller overall profit pool -- unless gas pricing moves to energy equivalence with oil, which is unlikely," said Nick Stansbury, head of commodities research at Legal & General Investment Management.

Investment in renewable energy for electricity generation is already outpacing fossil fuels globally, driven by falling costs of producing wind and solar power. More than half of power-generating capacity added in recent years has been in renewable sources, according to the IEA.

"Longer term it's the logical thing to be doing if you believe that the gas market has got more longevity and is going to continue growing," Wood Mackenzie analyst Tom Ellacott said.

Big oil companies are working to drive down costs, secure buyers and leverage their market clout to maximize returns. Shell pushed back the approval of its Canadian LNG project by two years and split it in half as it worked to bring down the costs. It expects the project to generate an internal rate of return of 13%.

The moves point to the potential for a more sober oil-and-gas industry, less prone to the dramatic slumps that come with oil-price cycles yet with equally less promise to reach heady peaks.

"You will see lower return on investments for some of these [gas] projects," said Espen Erlingsen, a partner at Norwegian consultancy Rystad Energy. "I guess that's something they have to live with."