Energy Investments in a Transitioning Environment

Energy Investments in a Transitioning Environment

Energy Investments in a Transitioning Environment

Energy Investments in a Transitioning Environment

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Q: With demand down due to COVID, does it still make sense to be overweight energy?

A: The oil demand decline was unprecedented, and has received significant market attention. However, we are already experiencing a demand recovery with demand from non-OECD countries nearly back to pre-pandemic levels, with the most significant remaining demand declines from OECD countries attributable to the decline in jet fuel. While jet fuel accounts for only 7% of total oil demand, the ~50% decline in jet fuel demand is the largest remaining impediment to a return to levels approaching pre-COVID oil demand. We expect jet fuel demand to improve over the next two years as vaccination efforts gain traction.

What the market isn’t paying enough attention to, in our opinion, is the decline in non-OPEC supply, particularly from North American shale producers. North American production is down nearly 2MMbpd1, or 2% of pre-pandemic global supply, driven by high-decline shale. While OPEC will return to pre-pandemic supply levels as demand recovers over the next two years, the high decline rates in North American shale combined with rig counts that remain below levels that are required to sustain even current, now-lower production levels means that shale production will not return to pre-pandemic levels unless drilling activity picks up significantly. This will require a higher oil price, and shale producers struggled to generate positive cash flows even when oil was at $60-70 per barrel. This loss of 2MMbpd of production is nearly equivalent to pre-pandemic OPEC spare capacity. Supply is becoming a bigger concern than demand over a 2-year time horizon.

Q: Are you concerned about structural changes in oil demand due to COVID?

A: We are, and we are accounting for them, and yet what we are seeing in the demand recovery thus far is encouraging. China is our best guide for what post-pandemic behaviors might look like given its efforts to combat the virus, and total China oil demand is already back above pre-pandemic levels. This includes domestic flight activity that is nearly back to pre-pandemic levels. While miles driven globally have not returned to pre-pandemic levels, they have begun to recover, but gasoline demand for passenger automobiles contributes only 20-25% of global oil demand. Our valuations are predicated on oil demand not returning to pre-pandemic levels until 2022-23 due to a combination of lower transportation demand (gasoline for automobiles, jet fuel for air travel, particularly in OECD countries) that offsets resumed growth in non-transportation oil demand (petrochemical demand and industrial demand, primarily in faster-growing non-OECD countries). This accounts for the structural behavioral changes we anticipate due to COVID. Thinking longer term, we do not expect global oil demand to return to its long-term 1-2% growth trajectory for the first time in modern history, which underscores our expectation for lower structural demand for oil going forward.

 

Energy Chart

Q: Where do oil companies fit into investment portfolios as the world prepares to dramatically de-carbonize?

A: We are counting on the world to de-carbonize, and it underpins the investment thesis for our energy sector investments. These companies constitute the vast majority our energy positioning and should be long-term beneficiaries of the energy transition.

The biggest headwind to oil demand in the energy transition should come from lower transportation fuel demand. Several developed market countries as well as China have set aggressive targets to electrify transportation. The impacts should first be felt by gasoline demand for passenger cars (20-25% of global oil demand) via increased penetration of electric vehicles (EVs), and then later by diesel demand for commercial trucks (15-20% of global oil demand) via the conversion to electric propulsion systems, hydrogen fuel cells, and compressed natural gas. While this transition will happen, the market isn’t properly accounting for three primary factors in the transition:

  • First, the gasoline demand decline will take time. 

    Even as the EV penetration rate of new car sales accelerates in this decade, gasoline-consuming internal combustion engines with average lives of 10-15 years (or more) will remain in the global fleet for a long time. Under a confluence of ambitious regulatory incentive regimes that result in EVs representing 67% of global new car sales in 2035, EVs would still represent only 33% of the global car fleet at that time and would pose less than a 10% headwind to oil demand over the next 15 years, or less than 1% per year. This is not enough of a decline to entirely offset the traditional demand growth from other uses of oil.

  • Second, oil demand is more than just passenger car demand.

    Half of oil demand is from non-transportation sources driven primarily by petrochemical and industrial uses, particularly in faster-growing non-OPEC countries. This demand continues to grow and will be more difficult to replace. In addition, the timeline to displace transportation demand for commercial diesel is longer than that of gasoline for passenger vehicles, and diesel demand will likely grow into the next decade. Even under an ambitious scenario in which governments incentivize a quick conversion of the transportation fleet away from oil, total oil demand is still likely to grow into the middle of this decade. 

  • Third, oil & gas production is more than just oil production.

    Natural gas will be an important part of the energy transition, both as a primary energy source as well as a complement to intermittent renewable energy sources. Natural gas emits 50% less carbon than coal and emits dramatically less sulfur dioxide, nitrogen oxide, and particulate matter. Natural gas, and LNG in particular, represents a growing market that stands apart from that of traditional oil demand. Coal as a percent of the global energy mix has remained stubbornly high and the transition in Asia away from baseload coal-fired generation to baseload natural gas will be a significant driver of reduced carbon emissions and improved air quality. Examples are plentiful, and South Korea’s decision to switch 24 coal-fired power plants to LNG by 2034 underscores the transition we expect to take place, which will support continued strong demand growth for LNG for years to come. 

In contrast, the decline in global oil & gas investment has been staggering. Global oil & gas investment is now 33% below 2015 levels, and the investment declines from shale producers and large independents in many cases have been even more significant. Prior levels of investment were only adequate to grow global oil supply 1-2% per year beyond offsetting natural decline rates, and the precipitous reduction in investment must now contend with underlying decline rates as high as 5%+ in conventional fields, 10%+ in offshore fields, and 30%+ in shale developments. It will be difficult to sustain current levels of oil & gas production at this lower level of investment, which suggests a shortfall in the oil & gas production required to get the world into and through the energy transition. With the end of the oil age on the horizon, investors are demanding better returns from shale and other oil producers, which requires more disciplined capital investment, which in turn will pressure global oil supply in the coming decade. While oil & gas investment needs to increase, this increase will require higher prices to incentivize that investment.

Q: What is your investment thesis with the energy investments in your portfolio?

A: We invest in our energy companies because they have peer-leading competitive positions, ability to grow their returns on capital over time, and trade at prices below our estimate of their values. We don’t make the investments because we want to make a particular “call” on a commodity price, but do recognize that the market perception of the long-term commodity price often creates our opportunity to own great companies in the sector at attractive prices.

As residents of this planet, we are concerned about climate change and eagerly anticipate the de-carbonization of the energy supply. Encouragingly, this movement is accelerating from both a societal and regulatory perspective, and this in turn creates investment opportunities as well as pitfalls through the energy transition. As value investors we try to capitalize on the long-term tailwinds created by the energy transition and especially the opportunities created by the transition that aren’t immediately appreciated by the wider market. This provides us the opportunity to invest in attractive long-term opportunities while still paying reasonable valuations. We believe the market is offering us such opportunities as the global economy recovers from COVID and the market continues to calibrate the timing and beneficiaries of the energy transition. 

 

1. MMbpd denotes million barrels per day

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