Anything but a smooth energy transition

Regrettably, much of public discourse over the ongoing energy transition has become almost binary in nature, and the world’s future energy mix is one of the most polarising topics. Disagreements, however, are fundamental to markets and, for investors who take a dispassionate view, opportunity abounds. 

Both the huge investment in the dash to net-zero and the dislocations in energy markets can be exploited, with the high stakes for the planet coming up against that other inconvenient truth: stubbornly high demand for fossil fuels. Based on the BP Statistical Review of World Energy (2020), fossil fuels accounted for 84.3 per cent of energy inputs in the year prior to the pandemic, a figure that has dropped by a paltry 1.8 percentage points since the start of the millennium.

Analysis from Schroders suggests that crude oil demand in 2022 will average 100.23mn barrels of oil per day (bopd) – well above the pre-pandemic level of 98.27mn bopd. That’s in line with short-term forecasts from Opec. Over a longer timeframe, the oil producers' cartel anticipates that an aggregate 7.9mn bopd reduction in demand from OECD economies will be dwarfed by a 25.5mn bopd increase from non-OECD nations. 

Transitioning from such dependence is a gargantuan task. The International Energy Administration (IEA), for example, estimates that to achieve net-zero emissions by 2050, annual investment in clean energy will need to triple by 2030 to around $4tn (£3tn). It will necessitate a 95 per cent reduction in industrial emissions, together with massive infrastructure investment, yet the transition will also be dependent on the roll-out of technologies that are not available yet.

The latest estimates from McKinsey on the cost of achieving net-zero by 2050 point to capital spending on physical assets of $275tn, an increase of $3.5tn on current annual spending (to put this into perspective, the US is forecast to register a gross domestic product of $24.8tn in 2022). Naturally, this would entail a complete reversal in capital allocations away from high-emissions energy sources.

Net-zero doesn’t mean zero emissions

Admittedly, the IEA, though nominally an independent advisory body, could arguably be mistaken for a green energy advocacy group at times. On the other side of the fence, Opec obviously has a vested interest in talking up the oil and gas industry. Above all, the examples provided suggest that it would be unwise to make too many assumptions on the pace of change in energy markets. There seems to be a disconnect between the coverage of the transition and what is happening on the ground.

The move towards a low-emission global economy could certainly gain impetus through existing corporate and state mandates, but it’s worth remembering that net-zero doesn’t mean zero emissions. The fast-gathering offset regime – a bugbear for climate campaigners – could simply delay substantive reductions in greenhouse gases, providing cover for companies that aren’t wedded to the idea of fundamentally altering their business models.

Contradictory noises from the world’s largest CO² emitters

At the  COP 26 climate summit in November 2021, China and the US – the world's two biggest CO² emitters – did put out a predictably woolly joint statement, declaring that they have agreed to “boost climate cooperation” over the next decade, whatever that means. True, China’s president Xi Jinping had previously pledged to end the financing of new coal power plants overseas, while reaffirming the country’s commitment to achieving carbon neutrality by 2060. But how does that square with plans under way to build dozens of new coal-fired power plants, along with a renewed strategic focus on energy security after numerous provinces in the country were plunged into darkness by rolling blackouts last year?

Hydrocarbon outlook not as bleak as some might have us believe

The quandary faced by policymakers in China; ergo, how to power economic growth while transitioning away from the use of fossil fuels, illustrates how environmental pledges can grind up against practical realities. Closer to home, UK households may take a slightly dimmer view of the transition as energy regulator Ofgem increases the price cap (by £693) on the cost of domestic energy, particularly if it is thought that the intermittent nature of renewable sources such as wind and solar have exacerbated the ongoing global energy crisis.

Given projections for global energy usage, the outlook for producers, especially those engaged primarily in oil and gas production, are not as bleak as some might have us believe. Certainly not in terms of pricing.

Evy Hambro, BlackRock International’s global head of thematic investing, recently predicted that commodity prices, including those for oil and gas, could remain at elevated levels for many years, possibly decades. Oil prices recently posted a seven-year high, and the supply-side continues to tighten as inventories shrink. In the first two months of the year, the US normally builds inventory ahead of the summer season; this year, inventories have fallen by almost 1mn barrels a day.

Upstream disincentives = price volatility

Why is this playing out now? We can go back to the oil price slump of 2014-16, which, according to some, was engineered by the Saudis to try to force lower-margin US shale producers out of business. That seems a somewhat scurrilous conjecture, especially as efficiency gains in the US shale sector lowered break-even prices, leaving Uncle Sam as the de facto marginal cost producer globally. Whatever the trigger, the resultant 70 per cent drop in the price of crude oil acted as a major disincentive for upstream investment, effectively eliminating billions of barrels of future production. To make matters worse, global upstream investment in the sector fell by about a third during the first year of the pandemic.

Given the lengthy lead times associated with conventional oil and gas production, it was perhaps inevitable that prices were going to spike as soon as global demand picked up as the pandemic restrictions eased. The only question is the extent to which crude prices could be contained if Saudi Arabia was to bring its spare capacity to bear, although Saudi officials have often been accused of opaqueness in this area. At last year’s Nikkei Global Management Forum, Amin Hassan Nasser, chief executive of Saudi Aramco (SAU:2222), indicated that a rebound in air travel would quickly consume the world's spare production capacity. Nasser went on to point out that by 2050 there will be an estimated 2bn more energy users across the globe, with population growth “led by developing countries, where energy transition will be much slower".

It may be that we will see a two-speed energy transition given the difficulty in aligning twin objectives of maintaining economic output and keeping global warming below two degrees. The reality could be that we witness further dislocation in energy markets, evidenced by an increase in fundamental pricing mismatches for energy suppliers. Anyone picking up a power bill from April onwards will need no reminding of what this usually entails.

Fuel poverty and world energy security

If experiences in Germany and California (both have seen rising wholesale energy prices and increased dependency on natural gas to counteract intermittency) represent the template for the push towards renewables, public support for green energy initiatives could start to wane once realpolitik takes hold of the collective psyche. The previously cited McKinsey analysis also states that “the impact of the transition would be felt unevenly across sectors, countries, and communities”, with “extensive labour reallocations” and the risk of “energy supply shortages and price increases”. Recent events have certainly underlined the latter point and you are left wondering whether electorates would countenance widespread labour reallocations (ie job losses) and a general fall in living standards even if they are concerned about the impact of global warming. We shall see.

This article is an abridged version of Mark Robinson's full energy sector report for our IC Alpha subscribers. You can also visit the AlphaScreens section of the website to find a selection of results from our bespoke stock screens - the latest revamped momentum screen for Alpha highlighted energy stocks on both sides of the Atlantic which are worth further investigation.