Asset managers deliver brutal verdict on oil
Oil and gas companies must rapidly adapt to declining long-term demand or they will face stark financial consequences, asset management giants warn
Institutional investors are increasingly concerned about the financial impact of climate change risks on the investments they hold. In response to their clients’ demands, asset managers have for years been engaging with fossil fuel companies to reduce their carbon footprint and adapt to the energy transition.
Environmental, social and governance (ESG) strategies, which factor in climate change risk criteria, have gone mainstream in recent years. A major turning point arrived in January when the world’s biggest investment manager with assets under management (AuM) of c.$6.5tn, BlackRock, announced sweeping changes to its investment and engagement strategies and joined the Climate Action 100+ pressure group.
Managers have already moved beyond simply excluding carbon-intensive companies from just their bespoke ESG investment funds. They are also doing so—as well as exerting more and more pressure on companies at annual general meetings—through their core investment strategies, which have many times greater AuM.
Coal has been the most obvious target of exclusion for climate-concerned investors but this approach is filtering down the value chain to other fossil fuels. For example, BNP Paribas Asset Management committed to align all of its portfolios with the ‘well below 2°C’ Paris Agreement a year after it was signed in 2015; it set itself an overall target of 2025, but started by excluding coal from its portfolios from January 2020.
"Coal was the first to go as it is the most carbon-intensive fuel. Going forward, we will be looking very closely at other industries that have high carbon intensity,” says the firm’s global head of sustainability research, Mark Lewis. “We will be looking to see how we might make sure the investments in those industries are also consistent with the Paris Agreement."
Analysis by Legal & General Investment Management (LGIM) paints a bleak macro future for the oil sector. “If we look at a Paris-type energy mix versus a business-as-usual-type energy mix, thermal coal comes out fastest, but oil comes out on our analysis pretty close behind,” says the £1.2tn ($1.46tn) AuM asset manager’s head of commodities research, Nick Stansbury.
“We think oil will see up to a 60pc loss of market share in the energy sector over the next 30 years, if the world is to get to the Paris target. It is a demonstrably worse macro environment for oil companies.”
There is a degree of scepticism over some of the major oil and gas companies' commitments to produce net-zero carbon emissions by 2050. It is going to be "pretty damn difficult to hold people to account on that", says Andrew Parry, head of sustainable investment at Newton Investment Management.
“The economic argument can no longer be made that fossil fuels will always make better returns than renewables” Lewis, BNP Paribas IM
Parry says he wants to see how commitments are integrated and aligned with corporate strategy before he takes them seriously. "What does this mean for your business strategy, and what does it mean for capital allocation over the next five to 10 years? That is the horizon that we can operate over as investors. How can we integrate this into the capital allocation model, how is it integrated into the management accounts?
“For example, an oil and gas company might report its carbon emissions under the Task Force on Climate-Related Financial Disclosures (TCFD), but if it then does not take [the associated] scenario planning and apply it to its management accounts, and actually into how it manages its business, there is a danger that it becomes tokenism."
This demand for solid detail is echoed by the £45bn Border to Coast Pension Partnership, a co-investment group created by 12 UK local government pension funds. “Companies’ commitments to being carbon neutral by 2050 are very positive, but we need greater visibility on how they are going to achieve this,” says its CEO Rachel Elwell. “That means companies need to set short, medium and long-term targets, with transparent reporting.”
The energy transition will still create new oil and gas opportunities for investors, according to LGIM’s Stansbury. “Around $30tn of net new capital needs to be injected into the [oil and gas] energy sector. So, the industry is likely to become significantly more capital intensive than it is today.
“The energy transition is very, very disruptive for the energy industry—but not necessarily catastrophic,” he adds. “A number of companies could present, to both us and our clients, very attractive long-term investment opportunities [despite] the energy transition.”
“Companies need to set short, medium and long-term targets, with transparent reporting” Elwell, Border to Coast Pension Partnership
The most attractive oil and gas opportunities are typically large energy companies that can lay out their transition strategy, he says. “Particularly ones that involve progressively investing less capital over time and returning more cashflow to investors. This is a strategy that potentially works in a consolidating and shrinking market, and involves running a less leveraged balance sheet. All of these things speak to an attractive set of opportunities for us as investors.”
Asset managers are also increasingly finding their clients want a dimension to their investment strategy beyond purely financial rewards. “More of our clients are asking us questions around how they can have an impact on the climate crisis, without sacrificing risk-adjusted returns,” says Stansbury.
Transition to renewables
During the past few years, the economics of renewable energy have become competitive with fossil fuels for power and revolutionised the way buy-side investors think about energy.
“We have seen renewable and alternative energy investments go mainstream in a huge way in the last two to three years,” says BNP Paribas’ Lewis. “And that is entirely down to the economics maturing at the same time as the outlook for fossil fuel energy is deteriorating. The economic argument can no longer be made that fossil fuels will always make better returns than renewables.
“If you look at how the market values companies that have a lot of renewable energy versus how the market values companies with a lot of fossil fuel energy, companies with renewable energy trade on much higher multiples—they are more highly valued by the market.”
But there is debate over the extent to which oil and gas companies should be moving into renewables, and at what pace.
Some investors would like to see rapid adoption. "The oil and gas majors are continuing to invest [fresh capital] in new and existing [oil and gas] projects—we are talking about hundreds and hundreds [of projects] and perhaps trillions of dollars over the next 10 years,” says Candriam global head of ESG investments and research, Wim Van Hyfte.
“I think the current consideration of renewables [by majors] is a real disappointment. The reason this is possible is because [many] oil majors refuse to provide transparency on their consideration of scope three emissions, the emissions that come from the use of their products.”
One company that stands out for its rapid shift is Danish firm Orsted, which is the poster child for transitioning from oil and natural gas (previously Dong Energy) to become a world leader in offshore wind. It is a darling of investors; as Petroleum Economist went to press its share price was less than 8pc off its all-time high despite collapsing energy prices—which is unimaginable for any oil and gas focused company.
“The oil and gas sector should start working on this. They will not have the same possibilities if they try to make a major shift in five years—it may be impossible,” says Van Hyfte.
“Most oil and gas companies worldwide are considering it because there is a lot of investor and regulatory pressure. But I do not think there are exemplary cases where we can say ‘wow, this company is setting out clear objectives for the future and looking to what it means for it today’."
But other asset managers do not think that, in order to play a positive role in the energy transition, oil and gas companies need to convert themselves into renewable power companies.
“It is not that we think they definitely should not—we just do not want to be black-and-white about it,” says LGIM’s Stansbury. However, he remains open to being persuaded that it is the right strategy for “some companies”.
“The energy transition is very, very disruptive for the energy industry—but not necessarily catastrophic” Stansbury, LGIM
Newton invests in oil and gas companies that are transitioning towards renewables, as Orsted has, says Parry. “But there are clear barriers to exit [oil and gas], and demand for oil and gas is still growing. It has been growing at 2pc-3pc per annum—aside from the recent drop in demand.
“A lot of people say ‘just redirect the cashflow into alternatives’, which they are doing in part. But whether the volume of renewable opportunities is there, and whether they can be brought on at a speed that means lost oil revenue is compensated for by the new revenue, is a more difficult question. I think for most of the majors it is not possible for them to do this in scale.”
There is also a technical accounting challenge. “For tobacco stocks, when volumes went down, taxation allowed them to hide price increases so their cashflow was actually pretty good. But the oil and gas companies do not necessarily have that benefit.”
Border to Coast’s Elwell does not think all of the oil and gas companies that are attempting to move into greener energy—and changing their business models to take into account a 2°C world—will be successful.
Has demand peaked?
Given oil prices have fallen into negative territory for the first time in history—due to collapsing demand during the coronavirus lockdown and massive oversupply—some asset managers are more pessimistic than ever about the oil sector’s future. Recent events “are a microcosm” of how a rapid energy transition is likely to impact the fossil fuel sector, according to Stansbury.
There is a legitimate question over whether Covid-19 will have a long-lasting effect on oil demand. Both BNP Paribas’s Lewis and Candriam’s Van Hyfte think this will be the case.
“This oil price drop is very different from 2014-15 and 2008-09, in the sense that some of that demand destruction could be permanent,” says Lewis. “[While] we will certainly be going back to a world where oil prices have recovered from the current levels, perhaps demand will no longer be on an upward trend. Will people travel a little bit less on aeroplanes? Will businesses be a bit more cost-conscious, having made cost savings [during the lockdown]? I think everybody is going to be looking for cost savings coming out of this crisis.”
He suggests consumption might already have plateaued. “You could ask that question on a reasonable basis now whereas, before the Covid-19 crisis, a lot of people were only saying that oil demand is going to peak sooner than the industry thinks.
“If the narrative asserts itself that demand is peaking, or may in fact already have peaked in 2019, that would take away probably the last remaining plank that supports long-term continuity of the industry along business-as-usual lines. Then that completely changes the long-term outlook for the industry."