Energy Investments in a Zero-Carbon World
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Investment Management ENERGY INVESTMENTS IN A ZERO-CARBON WORLD The energy sector is controversial. It faces a perfect (usually in the single to low double digits), whereas storm due to the short-term demand shock caused by the iron-ore and copper reserves are often measured in COVID-19 pandemic and the longer-term risk from the decades or even centuries. This means that at current reduction in society’s carbon footprint to combat climate production rates, under all scenarios for future oil change. Considering this uncertainty and the collapse demand, it is impossible for upstream reserves to in valuations in the sector, we are confronted with dual become obsolete due to inadequate demand for oil. scenarios: whether the sector presents an exceptional • With respect to new competitors, US shale has investment opportunity or is destined for obsolescence. We emerged as a powerful new supply source over believe the key questions are: the past few years. But we estimate that US shale 1. What is the risk that energy companies will be left with production requires an oil price of $60 per barrel or material stranded assets in a carbon-neutral world? more to be economical, underscoring the limits as to how much disruption shale can cause. 2. How will the coming energy transition impact the sustainability of energy companies? MULTI-DECADE DEMAND FOR OIL AND GAS This note focuses on the risks and opportunities presented It bears repeating that there is no scenario under by the upcoming transition for the energy sector. We which the demand for oil and gas will disappear in address company-specific issues as part of our research the next few decades. We see overall demand peaking framework that is bottom-up and fully integrates ESG in about 10 years and declining only slowly after concerns unique to each company. The details of Pzena’s that. Consider the long-range scenarios run by the integrated ESG framework are available upon request. International Energy Agency and BP p.l.c., to limit the rise in global temperatures to materially below 2°C by 2040 (Figure 1) that show overall demand for oil ASSET LIQUIDATION VALUES AND RISK OF STRANDED ASSETS and gas to be lower than 2018 by 21% (IEA) or 11% In all resource extraction businesses, metrics such as price to (BP) by then. Meeting these long-range scenarios will earnings are misleading because they do not account for the be challenging without a significant shift in energy natural depletion of the underlying assets, i.e., oil and gas policies around the world. reserves. Instead, it makes sense to price these companies Figure 1: There Will Be Demand for Oil and Gas for Many Decades to Come based on the liquidation of their reserves given their limited franchise value. We know a great deal about how to make DEMAND THROUGH 2040 such an estimate. We know the total quantity of reserves. 180 We know the future production and cost profiles. We can 160 162 162 therefore compute the value of the company’s reserves at a y 140 120 144 128 given oil price. If the future price of oil that is embedded in 100 the market’s current value of reserves is irrational, we can BoE/Da 80 60 buy or sell the stock. For a company’s reserves to become MM 40 stranded or obsolete, either I) the total supply of reserves 20 must exceed likely future demand, or II) new competition 0 IEA Sustainable BP Rapid with a significant cost advantage makes the exploitation Development Scenario Transition Scenario of this incumbent’s reserves uneconomical. We see both 2018 2040 scenarios as unlikely. Source: International Energy Agency; BP p.l.c. Measured in millions of barrels per day • Publicly-traded oil and gas companies have reserves that can typically be produced in a matter of years 1 | Energy Investments in a Zero-Carbon World – February 2021 The gravity of the supply shortfall is illustrated in been pivoting their downstream investments to reflect Figure 2. The grey line reflects current and estimated these trends. For example, European refineries account future demand levels under today’s policy regime, for only 30%–35% of the refining capacity of both whereas the orange line illustrates the BP scenario, Exxon and Shell. And motor gasoline composes only which is among the most aggressive. However, with no around 23% of the oil products sold in Europe for Exxon new investment and the 5%–8% drop-off in the natural compared to 58% in North America. Notwithstanding rate of production, supply is unlikely to meet demand the challenging environment for these businesses over under all scenarios as shown by the dashed line. So, the past few years, their returns on investment remain material new investment will be needed to meet future relatively robust as seen in the figure below. oil and gas demand; BP estimates that somewhere Figure 3: Near Double-Digit Returns Despite a Tough Landscape between $9 trillion and $20 trillion will be necessary to SHELL AND EXXON MAINTAINING RETURNS meet demand through 2050. Figure 2: New Production Needed Even in a Rapid Transition Scenario 30% DEMAND TO FAR EXCEED SUPPLY l 25% 180 20% 160 y 15% 140 10% 120 Return on Capita BoE/Da 5% 100 MM 0% 80 2014 2015 2016 2017 2018 2019 60 ‘10 ‘11 ‘12 ‘13 ‘14 ‘15 ‘16 ‘17 ‘18 ‘25 ‘30‘35 ‘40 Shell Downstream Exxon Downstream History BP Rapid Transition Scenario Current Policies Supply with no greenfield investment Source: Company reports Source: International Energy Agency; BP p.l.c. Oil Service Measured in millions of barrels per day To reiterate, even the most conservative oil demand forecasts require over $9 trillion dollars of spending to extract hydrocarbons over the coming decades. This is This need for investment implies that oil prices driven by the need to replenish and develop reserves to must be sufficient enough to allow companies to offset the natural rate of decline in oil and gas production. fund this investment and earn an adequate rate And because the current reserves of oil and gas companies of return. We believe that such a level needs to be support only 10-12 years of production, oil services will between $50 and $70 per barrel in today’s dollars. be needed for decades to support this effort. But because Interestingly, the average oil price over the last 50 there will be differences in the sustainability of business years has been right in the middle of this range models in the sector, investment selectivity is key. ($60), despite sharp, periodic, short-term volatility. The current share prices of oil and gas producers Figure 4: The Coming Capex Recovery: A Boon for Oil Services? ESTIMATING SPENDING TO DOUBLE BY 2030 underestimate the future investments required to meet global demand. 1,000,000 900,000 Downstream Refining and Petrochemicals 800,000 With useful lives of 30–40 years, downstream asset values D 700,000 US 600,000 are more sensitive to long-term demand changes. On s 500,000 400,000 the refining side, the rapid transition to electric vehicles MM 300,000 in Europe leaves a considerable risk of stranded assets. 200,000 In petrochemicals, concerns over single-use plastics 100,000 0 present a modest headwind to demand growth over time. E E E E E E E E E E E 09 10 11 12 13 14 15 16 17 18 19 However, assets should remain valuable depending on 20 21 22 23 24 25 26 27 28 29 30 20 20 20 20 20 20 20 20 20 20 20 their cost advantages and value-added product portfolios. 20 20 20 20 20 20 20 20 20 20 20 This segment is serving global end markets and Source: Rystad continues to enter new growth areas. (Plastic has been a key component of innovation.) Energy companies have Energy Investments in a Zero-Carbon World – February 2021 | 2 Rystad Energy, a leading energy consulting firm, believes We answer these questions by making three observations: that industry capital expenditures have bottomed in 2020 1. Not all transition plans are created equal. and are poised for significant growth over the coming decade. (See Figure 4.) 2. Opportunity is not priced in. 3. Engage, don’t divest. Asset intensity in oil services varies widely. For example, offshore drillships are long-duration assets and highly 1. Not all transition plans are created equal. susceptible to stranded asset risk; pressure-pumping trucks The opportunity to select from multiple energy sources wear down in just a few years, so their asset base and (e.g., oil, natural gas, wind, solar, etc.) for reinvestment profits adjust to shifting demand very quickly. Moreover, contrasts sharply with the last century when coal, then most of the oil service companies have relatively flexible oil, dominated the landscape. As a result, meaningful cost structures that they can adjust to varying demand strategy differences are emerging among companies. For conditions quickly to preserve profitability. (See Figure example, European and US integrated oil companies have 5.) Halliburton has exhibited this kind of resiliency and reacted differently to the transition, with those in Europe maintained margins in the high single digits amid sharply favoring renewables and those in the US focusing on lower revenues in the current downturn. short-cycle shale or conventional projects. Returns in new energy sources are likely to lag those of traditional sources, Despite meaningful differences in oil service business given lower technological and scale barriers to entry models and asset and customer bases, there’s little (localized competition, less challenging geology, etc.) and a differentiation in valuations.