Financial markets thrive on divided opinion. To function, they need both buyers and sellers; those happy to cash in, and those hoping the best is yet to come. But in one of the market’s largest sectors – by some measures the largest sector – investors’ opinions are becoming gradually, ever more starkly, polarised.
That sector is oil. Depending on who you ask, investing in an oil stock in 2018 is either financially reckless, unethical, canny, short-sighted or a necessary part of portfolio management.
As surveyors of the London Stock Exchange’s disproportionate slant towards hydrocarbons, this magazine regularly weighs the merits of each of these positions.
At present, we are yet to cross the Rubicon towards wholesale divestment. The world still runs on hydrocarbons, the exploitation and consumption of which we are all complicit in, whether we own shares in BP (BP.) or not. What’s more, the risks oil poses to our economic livelihoods provide ample reason to treat a stake in an oil company – or a FTSE 100 index tracker – as a hedge against inflation. We can also hope and call for change. For example, we think there are real signs Royal Dutch Shell (RDSB) is gradually pivoting with the energy transition from fossil fuels to cleaner energy. It should do much more.
But as our main feature this week reminds us (see page 24), this Good Money Week is as good an opportunity as any to question why someone should still be invested in the exploitation and sale of a product that is gradually cooking the planet. Yet as we will discuss, the financial implications of the energy transition are starting to echo the growing calls for divestment – regardless of ethical and environmental concerns. So why might investors think otherwise?
Hot right now
The first answer shouldn’t surprise. The unfortunate tendency within financial markets is to eschew long-term arcs like climate change or technological innovation in favour of shorter-term financial gain and familiarity. Call it the private equity fund manager in each of us.
If you’re an oil bull, you will have enjoyed the past month. After a bruising four years, Brent is back to $80 a barrel, and though the rise has been steadier and less dramatic than the crunch witnessed in 2014 and 2015, the price of crude has tripled since the start of 2016. Not since the US invasion of Iraq in 2003 has oil climbed in value this quickly.
On balance, there are more reasons to think Brent will march towards $100 than crumble back to $50. As we have argued several times this year, ongoing turmoil in Venezuela, together with the United States’ decision to cut Iran out of international markets, are very bullish signals. Were they not, it is unlikely we would have reports of airlines “aggressively hedging their fuel purchases one or two years in the future”.
But this isn’t a piece about what oil prices are likely to do in the coming months. It’s about the growing signs that investor attitudes towards the sector are bifurcating in extreme ways.
On one hand are the likes of Sadiq Khan and Bill de Blasio, the London and New York mayors respectively, who are calling for cities to pull their money out of fossil fuel extractors to help send “a very powerful message that renewables and low-carbon options are the future”. On the other hand are hedge funds, most major banks, the core of institutional capital and fund management, and the likes of Schroders (SDR), whose European equities head described his “optimism towards” the “cheap” and “attractive” sector earlier this year.
Caught in the middle are the largest producers, who are starting to talk a good game when it comes to climate change, while placing bets on oil’s long-term future and failing to campaign for a carbon tax system.
Hotspots
Schroders’ assessment of oil stocks – which relies on the rising demand projections of the International Energy Agency (IEA) – is a classic business-as-usual, value-based take on large-cap majors. But large-caps aren’t the only part of the sector that continue to excite investors. Look around the industry, and talk of ‘hotspots’ – be they attractive fiscal terms, frontier exploration, or new drilling techniques – continues to dominate.
It could involve an improvement in an oil region’s political risk profile, such as Iraqi Kurdistan. After a difficult few years, in-country operators such as Genel Energy (GENL) and Gulf Keystone Petroleum (GKP) can now count on reliable government payments, a stable operating environment to generate large amounts of cash and plan their next development projects. Both stocks have more than doubled in 2018.
Conversely, we might think of hotspots in terms of bustling corporate activity, for example the North Sea, where independents such as Serica Energy (SQZ) and Faroe Petroleum (FPM) jostle alongside a raft of privately held groups in competition for the maturing assets of supermajors. Speculation that private producers such as Neptune Energy, Chrysaor, Spirit Energy and Siccar Point might eventually go public only serve to heighten the interest.
Hotspots also focus on hitherto-unexplored geology. These include the waters off Guyana, where interest has expanded since ExxonMobil (US:XOM) struck oil in 2015 with the Liza discovery. Proximity to Exxon’s acreage has been the calling card of Alternative Investment Market (Aim) minnow Eco Atlantic (ECO), which was recently joined by Total (TTA) in its share of the Tullow Oil (TLW)-owned Orinduik block. So too Kosmos Energy (KOS), whose exploration programme off Suriname is 70km from some of Exxon’s recent finds.
Shale: too hot?
What unites each of the hotspots above is the speed with which investors can make money. If a well comes in, operating conditions improve, or a transaction transforms cash flows, then the share price reaction can be sudden, as earnings forecasts quickly multiply.
And yet the most prominent oil hotspot of this century, US shale, has been a highly questionable investment. That’s despite the vast capital that unconventional oil production has attracted and the surge in the country’s shale output to over 7.5m barrels per day. Not to mention the effects all of this has had on the energy market; in the words of John Shaw, a professor of structural and economic geology at Harvard University, “nothing has had a more profound impact on the US and global energy economy in the past decade than the emergence of shale gas resources”. To underline that point, the prolific Permian basin in West Texas now produces more than most of the individual members of Opec, and by some estimates is on course to pump 4m barrels a day within a few years.
Indeed, this has been an unparalleled story of revenue and production growth. But industry-wide, that growth has not extended to earnings, and shale’s cash flow statement continues to be fuelled by debt rather than actual cash generation. Last year, unconventional producers raised $60bn in debt, a 30 per cent increase on 2016.
Profits remain elusive. And now there are growing signs that investors are finally starting to lose patience with this cycle, and that the industry will be unable to respond.
This scenario is carefully outlined by Bethany McLean, the journalist who helped expose corruption at the top of Enron. In her recent book, Saudi America, she suggests that without “overheated investment capital” and historically low interest rates, “it’s not clear there would ever even have been a fracking boom”. Examining the apparently insatiable appetite for pension funds and private equity to fund fracking operations, Ms McLean writes that “in a world devoid of growth, shale at least was growing”.
In effect, however, shale’s lack of profits has only served to create “a greater fool business model” in the words of one private equity executive quoted in the book.
Operators’ response to such doubts has been to talk up ‘Shale 2.0’ – drilling wells more cheaply and more smartly. This is the chief bet BP has just made, in its $10.5bn acquisition of BHP Billiton’s (BLT) unconventional assets in the Permian, Eagle Ford and Haynesville basins – a network of wells BHP failed to make money from. Other reports suggest that the unmatched economies of scale possessed by Exxon and Chevron (US:CVR) are gradually creating a sustainable model for shale oil.
This might prove an uphill battle. With higher prices, cost inflation has once again returned. In fact, the sharp cuts made by rig crews and contractors in the downturn are estimated by some to have accounted for almost half of the savings claimed by the industry in its ‘re-set’. Indeed, the challenge of keeping the operating break-even level down (the point at which production generates free cash) might help to explain flatlining rig counts in the Eagle Ford and Bakken shales over the past year, despite rising prices. Some predict output could soon start to drop.
Not so hot
Whether US shale enters a period of consolidation, begins to decline, or continues to hoover up hot money may not matter. By far the most interesting passage in Saudi America concerns a series of conversations Ms McLean reports to have had with large private equity funds, who are no longer investing in oil and gas “not so much because of ethical concerns about the environment, but rather for the simple reason that they didn’t think the profits would be there for much longer”.
The flipside of that observation is twofold: the feasibility and desirability of new energies. Together, they represent the most devastating challenge to oil.
Over the past decade, the energy transition has shown it has legs, and that the substitution of renewable energies for fossil fuels is not just necessary to arrest global warming and air pollution; it is now technologically viable. The average global costs of running solar photovoltaic cells and wind farms are collapsing to around $50 per megawatt hour, according to Bloomberg New Energy Finance. That’s almost enough to out-compete the cheapest fossil fuel power, and lithium-ion batteries are not far behind.
According to a new report by London-based think-tank Carbon Tracker, this trend means fossil fuels have already entered the “peaking phase”. “This report is a warning to investors,” says its author, Kingsmill Bond. “The amount of money at risk is very dramatic.”
By Carbon Tracker’s own estimations, some $25 trillion of fixed assets are becoming ever-more vulnerable to stranding, as “one bastion of fossil fuel demand after another is stormed and overwhelmed by the rising renewable tide”. In corporate terms, this is likely to lead to rising competition, falling prices and massive write-downs as assets are abandoned. If energy demand growth continues at 1.5 per cent a year, and solar and wind supply growth continues at 20 per cent a year, fossil fuel demand is set to peak by 2023.
In five years’ time, renewables’ share of the global energy mix will still fall well short of fossil fuels’. But history has shown that the size of an incumbent industry offers no protection in and of itself. Horses’ replacement by cars, or electricity’s displacement of gas in domestic lighting both suggest that disrupting technologies need only reach a 5-10 per cent market share before the previous dominant market can be said to have peaked.
The pushback from oil and gas producers – that electricity only commands 20 per cent of end-use energy demand – need not affect the ‘peak’ effect, according to Mr Bond. “Most of the concerns that people have about the transition are end-game problems,” he argues. “[These] aren’t things that will stop an energy transition from happening in the first place.”
Compounding this trend is the question of where energy demand is likely to grow. As the oil majors have noticed (in their marketing of liquefied natural gas, or LNG), it will almost all come from so-called emerging markets. But as Carbon Tracker points out, developing countries’ capital expenditure on renewables has eclipsed developed countries’ in each of the past three years. In 2017, developing nations’ spend hit $177bn. And it is easy to forget that the clear majority of countries import fossil fuels, developing nations included. Renewables offer one path away from this reliance, a journey that makes economic sense, and which might just prove the one ‘hotspot’ oil companies are completely misreading.
Hot air?
This week, the heads of the world’s largest oil companies were set to gather in New York and speak gravely of the energy challenge. This clique, operating under the banner of the Oil and Gas Climate Initiative, has now finally been joined by US producers. According to a draft announcement reported by US news website Axios, Exxon chief executive Darren Woods was set to use the occasion to call for “collective efforts of many in the energy industry and society to develop scalable, affordable solutions… to address the risks of climate change”.
US majors’ registration of the global consensus arrives late, but is to be welcomed. Whether commitments to invest in carbon capture technologies, reduce methane emissions and improve energy efficiency represent a step forward, or a meagre set of gestures is another question. Short of seeking to sway government policy and campaign for the carbon taxes some of the largest oil companies now claim to back, one wonders whether oil majors are the appropriate leaders for any energy transition.
At present, what unites those majors alongside the IEA and even the likes of Carbon Tracker, is a reliance on projections for energy use and demand – even if their conclusions differ.
Yet in the coming months, the narrative is likely to fix on tightening supplies. If prices do rise, it may ultimately serve to exacerbate producers’ largest source of concern: demand. Even without it, there are growing signs that the tide may be turning. Just this month, in an echo of Carbon Tracker’s report, Norwegian risk management firm DNV GL suggested global oil demand will peak in 2023, and that no new oil developments are likely to be needed after 2040.
If there is substance to the forecasts of DNV or Carbon Tracker, we would hasten to add another prediction: that regardless of the tightness of crude supplies, oil company valuations are heading for a sharp and violent shock in the next couple of years. For investors, the question is slowly starting to shift from whether to ever pull the plug – to when.
