Effectively the world is living off major investment decisions in oil and gas that were made before the oil price fall in 2015. If nothing changes, hydrocarbons markets could tighten even more, triggering even higher-than-expected price hikes.
Investors have been deterred from the energy sector for two reasons. First, perceived ESG concerns may lead to further derating. In fact, deteriorating support for the sector has pushed oil stocks to extremely low valuations with a price/free cashflow ratio near 25-year lows (Display, below). Second, a collapse in demand for hydrocarbons may leave unused reserves “stranded” and effectively worthless.
In our view, stranded asset fears are misplaced. We think energy stock prices are predominantly valued on a discounted cash flow analysis based on existing projects; that means no value is placed on fields that aren’t yet producing or will produce soon. Most oil and gas companies have about a 10-year reserve life—a period in which fossil fuels will be critical for a smooth energy transition and short enough for investors in select oil and gas stocks to receive satisfactory returns. And if investor aversion continues to act as an additional brake on investment, energy prices will remain high, buoying cash returns to shareholders.
Balancing Environmental and Social Concerns
For ESG-focused investors, the backlash against big energy is understandable given the environmental damage of fossil fuels. However, because of the dynamics of the transition to renewables, we think there is a social dimension to consider as well.
A chronic energy deficit will hit poor countries and poor people hardest. For instance, if lack of power disrupts irrigation in poor countries, water and food will be in short supply. In developed countries, poorer people could be forced to choose between food and heating their homes in winter as prices spike.
Policymakers will find it challenging to maintain the consensus for energy transition if people suffer and businesses shut down because of higher energy costs. How long can they ride out a backlash from voters? As the IEA comments:
“The wholesale transformation of the energy sector cannot be achieved without the active and willing participation of citizens. It is ultimately people who drive demand for energy-related goods and services, and societal norms and personal choices will play a pivotal role in steering the energy system onto a sustainable path”
Wider Perspective Presents Practical Solutions
Faced with this complex picture, governments and investors need to take a more nuanced view of ESG issues to help enable a credible transition journey to net zero. If the journey is fraught with adverse near-term outcomes for society, it will be hard to reach the destination on time.
Currently, some major oil and gas companies are redeploying their hydrocarbon cash flows to invest in and develop renewable businesses, including associated infrastructure such as electric vehicle charging points on fuel station forecourts. And switching from dirtier hydrocarbons such as coal to cleaner ones like natural gas is also an important interim step on the journey.
Consequently, we think that oil and gas companies with credible energy transition strategies are actually part of the solution and deserve closer attention from investors. Not only that, as these companies progress their corporate transformation plans, they will unlock value in next generation businesses in renewables and charging stations. The hydrocarbons industry has developed wide-ranging expertise in some of the critical areas for the energy transition. Logically, this makes select oil and gas stocks natural partners for governments and other stakeholders (Display, below).