Global supply and demand of liquid fuels both breached 100 million barrels per day (mb/d) for the first time in 2018. As arbitrarily symbolic as that number is, behind it lies a broader, constant trend spanning several decades: economies are growing and require more energy, pushing continued demand to further expand the world’s cheap and accessible supply of it. Yet there is a simultaneous need to limit the rise in global temperature to below 2°C under the Paris Agreement. So how do oil and gas producers fit into this story?
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Global supply and demand of liquid fuels both breached 100 million barrels per day (mb/d) for the first time in 2018. As arbitrarily symbolic as that number is, behind it lies a broader, constant trend spanning several decades: economies are growing and require more energy, pushing continued demand to further expand the world’s cheap and accessible supply of it. Yet there is a simultaneous need to limit the rise in global temperature to below 2°C under the Paris Agreement. So how do oil and gas producers fit into this story?
The Energy Transition is Weighing on Energy Equities
The uncertainty that the transition to cleaner energy is creating has been most apparent in energy stocks. Equity markets have rallied strongly since 2015, with the MSCI World Index up by 25%. Yet the energy sector (as measured by the MSCI Energy Index) has lagged the broader equity rally by a wide margin, falling by 10%. So what is going on? The energy industry has battled low energy prices, but the green transition has also fuelled bearishness towards the sector.
Poor returns and investors chasing volume over value have indeed hurt oil producers. The 2012-14 era of $100+ per barrel oil prices lulled the industry into a belief that this was the breakeven cost of the marginal oil barrel required to stimulate investment. Consequently, costs exploded, returns plummeted, and then the shale revolution came. Since then, there has been a complete shift in mindset away from volume growth to value and returns.
Climate change is the other factor weighing on energy equities. The shift in attitude towards investment in oil has come as everyone from non-governmental organisations, to investors, to the International Energy Agency (IEA) has placed sustainability at the forefront of their respective strategies. Concerns about risks associated with investment in fossil fuels have moved from the fringes of the investment industry to centre stage in recent years. More than 370 global institutional investors representing a combined total of $40 trillion of assets under management belong to the Climate Action 100+ group, an investor initiative established to ensure the world’s largest corporate greenhouse gas emitters take the necessary action on climate change. And BlackRock, the world’s largest asset manager, recently joined the group. Unsurprisingly, investment flows into the energy sector have weakened materially with this pressure mounting on numerous fronts. Net outflow of investment in the sector amounts to $8.4 billion since the start of 2019. On the contrary, inflows into environmental, social and governance (ESG)-oriented funds have risen remarkably.
The Transition Will Be Slower Than Markets Are Pricing in
So what are the implication of such trends over the next two decades? The composition of energy supply will change – that much is obvious. Coal and oil will lose their market share to ‘greener’ alternatives such as renewables and natural gas. But it won’t happen immediately. Oil and gas currently account for 55% of primary energy demand and we expect that share to fall by only three percentage points by 2040.
And this is the crux of the argument. While equity markets are trying to price oil demand crashing, we foresee a much slower transition, especially as oil and gas production will be the primary source of funding for any transition.
Oil and gas producers will need to reduce supply by 40% over the next two decades to meet the International Energy Agency’s scenario of employing technologies to limit temperature rise to 1.75°C above pre-industrial levels by 2100, according to a recent study by the think tank Carbon Tracker. The market capitalisation of today’s main, publicly listed oil companies is $4.3 trillion. If we assume the 40% supply reduction is transferred to ‘oil value’ that needs to be replaced, oil and gas companies will need to find $1.7 trillion of value in greener alternatives such as wind or solar to maintain their current market capitalisation.
The Sun Does Not Always Shine, the Wind Does Not Always Blow
While investors recognise the dangers of ignoring climate change, they also demand return on their investments. Looking at earnings per share and free cash flow metrics across the oil and gas, solar, and wind sectors reveals the startling reality of the challenges facing the energy transition.
ExxonMobil, one of the largest oil companies in the world, generated an average of $16 billion per year of free cash flow over the past decade (Fig. 1). Meanwhile, the largest wind generating company, Vestas, generated an average of $0.7 billion per year of free cash flow over the same period. SunPower, one of the largest listed solar cell companies in the world, generated a negative free cash flow of $250 million per year on average.
Earnings tell a similar story (Fig. 2). ExxonMobil’s earnings per share equated to almost $6 between 2008 and 2018, substantially more than the $2 generated by Vestas and negative 66 cents by SunPower over the same period.
The Bottom Line
These numbers serve only to highlight the dangers of vilifying and demonising the oil and gas sector, which currently pays the bills for governments, investors, and the energy transition itself. Oil is here to stay for the foreseeable future and will have an important role to play, especially as revenues from such activities will fund the energy transition.
Figure 1: Free Cash Flow by Sector
Source: Bloomberg, Energy Aspects
Figure 2: Earnings per Share by Sector
Source: Bloomberg, Energy Aspects
Virendra Chauhan has been an Oil Analyst at Energy Aspects for the past seven years, and previously worked in Oil and Gas Equity Research at Nomura.
(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)