Investment Outlook In The Current Energy Transition

Europe and Asia are still in the throes of a gas price shock; and the effects have rippled through the global energy market. In Germany, for example, gas imports for the first eight months of the year were 0.8% lower than year-ago levels, but the bill was 55.5% higher, according to data from the trade statistics office. In the United States, the Energy Information Administration projects a 43% hike in costs this winter over the previous one, for homes using heating oils as primary space heating fuel. For homes using natural gas, the projected hike in cost is 30% between 01 October and March 31, as the commodity’s futures reached a seven-year high this year.

In China ― the world’s second-largest economy and also critical to the global supply chain ― spiking power prices recently triggered global stock and bond market wobbles. The country’s factory gate prices for September were 10.7% higher over year-ago levels, the steepest rate in 25 years, The Wall Street Journal reports.

Higher energy prices often add to inflationary pressures which, with the recent spate of power outages could lead to lower economic output and a slower economic recovery.

High natural gas prices ― which, in Europe and Asia, are still higher than oil on a per MMBTU basis ― if sustained, may lead to a gas-to-oil switch among industrials, driving an increase in oil demand. Estimates of the draw on oil range from 500,000 to 600,000 barrels per day (bpd), which would put upward pressures on oil prices. Brent grade futures last week topped US$84 per barrel; a level not seen since October 2018. Price for West Texas Intermediate (WTI) grade has risen more than 65% this year; its prompt timespread widened significantly just recently. While traders stand to reap substantial near-term windfalls, there are significant uncertainties in the outlook for upstream oil and gas investment.

Outlook

Even while posting massive cash flows, many oil majors are not ramping up their upstream capital expenditure; and given pressing budgetary requirements, most national oil companies in petrostates are likely to toe that line.

Capital expenditure for the oil and gas industry in 2021 is estimated by the International Energy Agency, IEA, to be US$330bn; while this may not be very different from the value for 2020, it is substantially lower than its stated value of US$497bn for 2019.

The agency’s chief energy economist stated in its World Energy Outlook 2021 that “… today’s oil and gas investment is really geared towards a future in which consumption is stagnant or even in decline". This sentiment will likely underpin investments going forward, and three items are noteworthy:

1. Alternatives

Higher oil and gas prices would hasten the quest for alternatives such as renewables, which are becoming increasingly cost-competitive, particularly in electric power generation. In 2020, the S&P Global Clean Energy Index soared 142%, and more than US$16 billion was raised by companies in early-stage climate investments during the first half of this year, Bloomberg reports.

Major oil companies such as Shell (RDS-A) and ExxonMobil (XOM) have come under pressure to adopt clean energy protocols. Chevron (CVX) is the latest to join. And similar to the case with ExxonMobil, an activist investor who has built a position in Shell, is seeking to break up the company into two (renewables-focused and legacy) units.

While some countries, China included, have ramped up their coal output ― and that, due mainly to the current energy crisis ― coal power generation in the United States peaked in 2007 at 2,016 terawatt-hours and has since fallen by 62% to 774 terawatt-hours in 2020. In the same period, electricity generation by renewables rose from 353 terawatt-hours (8.5% of total generation) to 792 terawatt-hours (19.8% of total).

2. State And Industrial Policies

The future of energy will be defined invariably not only by policies, but also by the capacity to enforce them. Among EU countries for example, regulations mandating increased engine efficiencies as well as strict emissions control will affect the demand for liquid transportation fuels such as gasoline and diesel. Earlier in the year, the EU ruled out funds for fossil-fueled vehicles and power. In addition, some EU countries are proposing a zero-emissions mandate in that sector by 2035. And the impact has been evident: Electric Vehicles (EVs) accounted for significant proportions of all new vehicles sold in Europe (15%) and even China (12%) for H1 2021, according to Canalys. For EVs and clean energy-powered vehicles, China is setting an ambitious target of 40% share of all vehicles in the country by 2030.

Automobile manufacturers are already committing to phasing out Internal Combustion Engines (ICEs) in the near future. Volkswagen (VLKAF) and GM brands for example, plan to phase out ICEs by 2035.

A proposal by a coalition of industry giants (including Amazon, Unilever, Michelin, Ikea among others) to use only ships that run on “zero-carbon” fuels by the year 2040, could have significant impact on the sale of residual fuel oil and gas oil.

Carbon and methane levies are high on the list of emissions mitigation policies. The energy consulting firm, Wood Mackenzie, recently estimated that a US$150/tonne carbon price would cause the value of the world’s 38 largest International Oil Companies (IOCs) to drop by 27%, or US$465 billion; and that a high carbon tax could erase 60% of Asia’s refining margins.

An oil and gas industry group in the U.S. state of Texas is raising objections to budgetary items currently being considered by the U.S. legislature. The group claims that what it considers a methane tax along with a repeal of other deductibles, will lead to the loss of more than 120,000 upstream jobs in the state.

Energy price caps have been responsible for the recent failure of some European energy suppliers. And even more recently, some of the largest French banks indicated their pullback from shale oil and gas financing. A group of more than 23 major insurers had earlier announced termination of underwriting services to the coal industry as well as specified oil and gas projects.

3. Fundamentals

Upstream capital investment in the oil and gas sector has been trending lower over the past few years; and if that trend continues, global oil supply will likely decline, compounded by ageing fields and other production decline factors. And that cuts across several production regions such as in Angola and the U.S. shale patch (excluding the Permian Basin).

Analysts at Morgan Stanley in a recent report, projected that global oil supply is likely to peak earlier than the commodity’s demand. The report noted that oil, which accounts for 31% of primary energy supply, has only a 20% share of supply growth rate and declining by 0.5% per year.

With energy demand set to maintain its upward trend as oil supply declines, some analysts expect an oil price shock ― or two ― in the near-medium term, citing the likelihood of a delay or failure in making up the shortfall.

Balancing Act

There is little doubt that the energy transition has created quite a bit of uncertainty with regard to longer-term oil and gas investment. The issue of “stranded assets” ― those acquired at significant costs but which costs may not be recouped due to regulatory and, or economic factors ― is a stark reality.

Oil and gas companies are currently re-evaluating their business models. Publicly-listed companies operating in the United States shale patch for example, are showing unusual production restraint in the current price regimes; instead, prioritizing cost cutting, shareholder returns and debt reduction. The few that earlier indicated their intention to increase production, saw their share values fall significantly.

The sector majors are laboring under demanding Environment, Social and Governance (ESG) protocols, as well, the associated policies.

There have been mergers and acquisitions, divestments and consolidations; and more may be in the offing. And with the recent price swings, some high-yield debt investors may be wondering if that is the new normal for the debt of energy companies in an energy transition.

During upcycles, companies would easily provide adequate shareholder returns while still retaining adequate capital for core business deployment. However, even with the recent cashflow bonanza, most oil and gas companies face a delicate balancing act: sustaining an oil and gas business while ensuring a low carbon operation. Some have, tongue-in-cheek, likened it to trying to ride two horses simultaneously.

All said, the current upcycle does present a strategic outlook and repositioning window for the energy transition.

Disclosure: None.

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William K. 2 years ago Member's comment

Certainly the whole energy structure is changing, and just as certainly it is not getting better. Those claiming that fuel use and consumption are exclusively responsible for every bit of climate change are promoting some very fundamental changes that will lead to huge reductions in human freedoms and also prevent advancements in large sectors of the world population, because advancment does require more energy. That fact should be obvious to everybody: Energy availability reduces the need for human labor to provide survival, and allows humans to advance beyond spending all their effort just to have food to eat. Basics like light and clean water do require energy, as does growing enough food to stay healthy. And the present capture of renewable energy is inadequate to the task.  Consider that burning wood and dung for heat is using renewable resources while generatig lots of pollution.

And the very worst will come when the realization hits that the climate change is a natural cycle and that the world can adapt to a warmer climate very well, and there is nothing that can stop it. Certainly things will change and less energy will need to be spent on keeping warm. Things may not be the same and those regions that are too cold for crops may now work very well for farming. POlar bears will move farther north and so will other species.

And an interesting situation will arise when enough of the population realizes that all of the sacrifices were in vain. Evolution does not stop, it has been going on all of this time, but nobody has noticed. Those who gained the most power and wealth by promoting the panic will not be willing to give up all that power and wealth without some conflict. The times will continue to change.