Oil companies are soon to be stuck between a rock and a hard place despite increased oil prices, according to energy analysts at J.P. Morgan.
Under pressure from consumers and governments to transition to new and greener energy sources, oil majors will have to "reinvent themselves," Christyan Malek, head of EMEA oil and gas research at the bank, told CNBC's "Squawk Box Europe" on Tuesday.
But this will increase capital expenditure and thereby hit shareholder returns, the companies' primary lure for investors, he added.
In a research note published this week, J.P. Morgan described a "trilemma" facing oil firms: traditional oil and gas revenue growth, energy transition to reduce carbon footprint, and returning surplus cash to shareholders.
And embarking on a greener path, adapting to what the bank called a "new energy order," is no longer something to be addressed in the distant future — the time for this investment is now, the note said.
J.P. Morgan's proprietary environmental, social, and governance (ESG) model suggests reducing the carbon footprint will require "significantly more investment, quicker than many realize."
"The industry has gotten to a point where they can no longer pay lip service, they have to spend dollars [on diversifying]," Malek said. "But they've got to do that whilst giving back cash to shareholders, as well as supporting the bread and butter business. To do all three is very difficult, and that is why we think the sector's risk-reward is, at best, challenged."
Fossil fuels divestments now total an eye-popping $6 trillion, with nearly 1,000 institutional investors having pledged to divest from coal, oil and gas under pressure from environmental groups, governments and increasingly conscientious consumers. This is according to a recently-published divestment report from Arabella Advisors, which revealed an increase in divestment from the 2016 figure of $5.2 trillion.
The growing movement has been led by the insurance industry but followed by universities across 37 countries, sovereign wealth funds, medical institutions, cities including New York, and the nation of Ireland. The Church of England last month voted to divest from fossil fuel companies if by 2023 they had not shown ample progress in abiding by the parameters of the Paris Climate Accord to limit global warming. Oil majors like Shell have publicly labeled divestment as a material risk.
Expanding beyond fossil fuels is therefore unavoidable, but requires, and will continue to require, greater spending alongside investing in traditional oil and gas projects. Adding capital expenditure for new energies means a roughly 10 to 15 percent increase in a company's total spend, J.P. Morgan calculated.
Reducing that carbon footprint is what will force companies to spend more dollars.
It's easy to overlook this challenge at a time of high oil prices and buoyant cash flow for oil majors. But it will remain an important factor in the investment decisions of shareholders, Malek said.
Amid what the analyst described as a "golden period of free cash flow" for companies, the focus is on lower capital expenditure and a higher oil price, and this should be the best part of the cash cycle for the majors. What many observers are missing, he said, is how "this is an unprecedented period in terms of transitioning for these business models."
Investor pressure has already made a difference. BP has aimed for zero net growth in its operational emissions and has invested £200 million in one of Europe's largest solar companies. Shell has pledged to reduce its carbon emissions by 20 percent by 2035 and 50 percent by 2050.
Shell, Exxon and BP have invested in natural gas projects as a means of providing energy while producing less carbon emissions. Still, the industry as a whole is not moving quickly enough on emissions reduction and lessening hydrocarbons reliance, critics say, thanks in part to the attractive profits currently stemming from loftier oil prices.
"We don't think of all the new energy spend as they start to diversify — there's a massive ramp-up in capex that is coming that's going to eat into new cash flow, the very thing that most of the bulls are citing as the reason you buy these companies."
The core selling point of these companies, however, is returning cash to shareholders, Malek said.
"If it's not growth, it's not value, they have to defend why institutional investors are going to be involved."
The companies best equipped to weather this transformation while delivering returns? Shell, BP and Repsol, J.P. Morgan said, remaining overweight on those stocks. Meanwhile, it's underweight on France's Total and Italy's ENI.
Key to a positive outlook, according to the bank, are companies offering long-term portfolio quality, a differentiated downstream position, lower energy emissions and competitive total shareholder return.