The answer involves lots of uncomfortable tradeoffs.
By Leslie Norton
ESG InvestingDemand for Oil Will Stay High. What’s an ESG Investor to Do?The answer involves lots of uncomfortable tradeoffs.
Leslie Norton22 September, 2022 | 4:08AMFacebookTwitterLinkedInFont-Size
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Oil prices are back down after the war in Ukraine drove record high prices at the pump earlier this year—but oil will still be in demand for a long time as the world grows and searches for credible alternatives. So what’s a sustainable investor to do? The answer involves lots of uncomfortable tradeoffs.
To help unpack the landscape for exploration and production companies as well as the name-brand integrated oils, we talked to David Meats, director of research, energy and utilities, and Allen Good, energy strategist at Morningstar. Edited excerpts of our conversations follow.
Leslie Norton: Fossil fuels look relevant for a long time, even if current price levels don’t make sense.
Meats: Yes, both [oil and gas] are at price levels that don’t make sense from a long-term perspective, in that the marginal cost of production for both commodities is much lower. Our midcycle price forecast for crude oil is $55 for West Texas Intermediate, $60 for United States Brent Oil BNO, and for natural gas, the midcycle price is $3.30 per 1000 cubic feet. We’re pretty positive on the long-term demand outlook for oil. We agree oil demand will peak around 2030 and decline afterwards. Where we disagree is that we think the magnitude of that decline will be less [than the market thinks]. Oil demand in 2050 according to our latest forecast is only 11% lower than the current level. We’re really bullish on the adoption of electric vehicles, but the 15-year lifespan for a typical vehicle means it takes a long time for those high sales to filter through to the vehicle stock.
Good: There’s dismissiveness of the sector. There’s certainly a higher cost of capital assigned to the industry for whatever reason. If we apply historical multiples to these same earnings, shares can be much higher.
Despite greater focus on emissions reductions and increasing [emphasis] on renewables, changing the foundation of the global economy takes time. Hydrocarbons continue to power the economy, and that’s unlikely to change soon. Oil and natural gas assets decline and need to be replenished. I don’t think these companies are facing a near-term threat.
Q: How are sustainable and ESG [environmental, social, and governance] investors supposed to approach fossil fuel?
Good: It depends on how the individual investor defines sustainability or ESG or their mandates. For some, any investment in fossil fuels is off the table. But if there needs to be some weighting toward energy and they want to be involved and underwrite the energy transition, then the Europeans would have more appeal, because you have explicit investments, targets for renewable power generation. They have advanced carbon capture and hydrogen projects to a greater degree than the U.S. firms. A much larger portion of incremental capital allocation is going towards preparing for the energy transition.
The integrated oils are participating in the entire value chain. The Europeans are large trading organizations. It’s a natural transition to put up EV charging. They already own all the retail stations, whereas the U.S. firms don’t. The E&Ps don’t have the same levers to pull as a global integrated—their option really is to reduce the carbon intensity of their operations.
Meats: In the late ‘90s, the tobacco companies did a Master Settlement Agreement with the government. They said they were making a socially harmful product, expected a long-term secular decline in demand, but wanted to be as responsible as possible, putting warnings on the packets, acknowledging the health risks. Oil companies are doing that too. In the 20 years after the MSA, the oil companies dramatically outperformed the broader equity markets.
Q: What do you think of the net-zero emissions commitments of oil companies?
Meats: It’s not an attribute that investors really should be looking at. Most of the integrated oil companies with net-zero targets are on a timeframe of 2050. We’re paying more attention to next year. And if [the target] doesn’t include scope 3 emissions, it’s not doing anything. More than 80% of emissions related to a barrel of oil happen downstream of the oil company, mostly from the tailpipe of your car, and that’s beyond the control of companies. I’d rather see energy companies that say that next year we’re going to lower our emissions by 30%, we’re going to eliminate flaring [burning of natural gas associated with oil extraction], we’re investing in carbon capture projects.
Good: It’s important to the extent that it influences today’s capital allocation decisions. The European integrated firms have to varying degrees committed to net zero by 2050. That’s why they’re investing in the renewables. That will ultimately determine the returns and growth over the next five to 10 to 15 years.
Q: How has the Ukraine war changed the thinking around fossil fuels?
Good: Today, you have very high prices as a result of the move away from Russian oil and natural gas. Longer term, you have the REPowerEU plant to accelerate hydrogen and renewable installation. I think natural gas demand has a fundamental support when you look at growing energy demands. For investors specifically, it opens up a lot more opportunities for liquefied natural gas. I don’t think you’ll see material change in investment from a lot of oil and gas firms just based off the need to meet the EU demand for natural gas. On top of the ESG overlay [investors thinking twice about investing in fossil fuels], you have Wall Street trying to enforce capital discipline. We haven’t seen a concurrent increase in budgets, and that’s unlikely to change.
Q: Which companies are furthest along in the energy transition?
Meats: The European companies are the most proactive about making bigger changes. But if an oil company pivots into a new area like offshore wind, it’s an area where the company’s expertise no longer counts and the competitive advantage it had in oil and gas might not be there. Offshore wind is a fiercely competitive space where it’s harder to eke out a durable competitive advantage.
The U.S. firms are working hard to address those emission issues. “I’m going to keep making oil because the world needs it, but reduce the emissions involved in extracting and producing as much as I can.” It’s about being the most responsible corporate citizen while still maintaining the current business model. One way to reduce emissions is by using more electric power in the field. Companies now, particularly in the Permian Basin, are using electrified drilling and fracking operations, and that’s helping. Another is by minimizing the use of flaring.
Good: In 10 to 15 years, the U.S. firms will still be much more focused on hydrocarbons, whereas the Europeans will have much larger renewable, low-carbon businesses. The European firms are not only pursuing long-term emissions reduction targets but explicitly investing in non-hydrocarbon businesses and the non-hydrocarbon value chain, such as solar and wind and electricity distribution and trading, with a focus on EV charging. Over time, those businesses will grow. BP BP is by far the most explicit in saying that 40% of their oil production will have declined by 2030. Shell SHEL has said their oil production will decline 1% to 2% per year. I think TotalEnergies TTE is going to grow for the next few years, plateauing around 2030. Certainly, they have a view that hydrocarbons will have a much longer demand. They think that they have relatively low-cost resources that can be developed.
Q: Which U.S. companies are furthest along in reducing carbon intensity?
Meats: Pioneer Natural Resources PXD has the lowest carbon intensity measured in tons of carbon equivalent per barrel of production and the most aggressive targets. It’s best in class in terms of least flaring and the most electric field operations to reduce its scope 1 and scope 2 emissions. Another one is Diamondback Energy FANG. It’s already using carbon offsets to account for the portion of emissions that happen downstream. So, it’s more advanced in that way.
Pioneer and Diamondback have narrow moat ratings, based on the fact that both operate in a particularly lucrative part of the Permian Basin. The Permian Basin is a geologically advantaged area in Western Texas, which has very low supply cost. So they enjoy a slight cost advantage over their competitors. They get more generous margins because when you drill a well there, you get more bang for your buck. So, both of those companies have historically been companies that we liked.
We’re in a top-of-the-cycle environment right now. So, it’s not the time to be putting money into oil and gas. But that’s nothing to do with sustainability or emissions. That’s just because the oil prices are really high.
Q: What about Exxon XOM and Chevron CVX?
Good: In terms of emissions, Exxon and Chevron are worse than the E&Ps. This is related to production mix. A relatively high heavy oil mix weighs on emissions.
Q: Which of the integrated oils do you prefer?
Good: The European integrateds are much cheaper than the U.S. firms on a variety of valuation metrics, including discount to our fair value. European integrated firms such as Shell, BP, TotalEnergies, have more explicit and aggressive transition strategies, along with long-term emission reduction targets. Clearly, they’re not being rewarded in the market. Amongst the Europeans, my ranking would be Total, Shell, and then BP. Total has been relatively aggressive building out renewables quickly. Shell is interesting in that they are the world’s largest LNG player. The rerouting of Russian volumes will benefit them. BP probably has the largest Russian overhang given their position in Rosneft.
However, that transition holds risks and competition is stiff. I don’t think you’re going to start meaningful earnings contributions [from renewable investments] until post 2025, 2026 and then really not until 2030. All three will be producing oil for a long time and increasing production and trading of natural gas. Are you an oil company or a renewables company? This leaves them without a core constituency of shareholders. This likely contributes to the discount.
That said, their cash flows are real. They’re buying back shares. They’re returning dividends. If oil and gas are structurally higher over the next five to 10 years, they will certainly lag Exxon and Chevron. You’re still getting the cash flow and the dividend yield and the repurchases in the meantime. If you’re really a long-term holder, your bet on the Europeans is that they will grow these renewable businesses and that business value will be recognized in the share price.
If I were ignoring valuation, I would recommend Exxon and Chevron in an environment where oil and gas is going to remain higher for longer.
Q: Thank you very much.