If you’re an ESG investor, you should be investing in big oil and gas. I know it sounds counterintuitive but hear me out.
A decade ago oil and gas companies were generally horrible investments, regardless of your stance on the environment. Corporate governance was dreadful, capital allocation was reckless, and little time was being spent on thinking about what happens after oil. The environment definitely wasn’t something the companies were thinking about and sustainability was still technologically difficult – we didn’t have a cost efficient way to produce renewable electricity or power electric vehicles.
Folks who invested in energy expecting big returns as we entered the shale revolution rode a wild rollercoaster up and down and ultimately didn’t end up making a lot of money. Aggressive exploration and production led to surpluses and overpriced deals. Avoiding energy companies back then was the right call, whether you did it for environmental reasons or not.
Today’s energy companies are substantially different, both in terms of how they’re operated, and how they think about renewables.
Fossil Fuel Demand:
Today’s energy companies operate with a much more realistic set of expectations about the future. They, like the general public, understand renewable energy is the future. Partially as a response to the environmental campaigns waged over the last decade, they are cognizant and supportive of the eventual power transition. Energy company operators everywhere are on board with that perspective. You may hear different timelines and projections for the transitions to renewable power, but at the end of the day most new power generating projects are renewables regardless of whether you live in Texas, China, or California.
However, even as renewables become more viable, we also need to be realistic about how to frame the transitional period. We still need fossil fuels. Some environmentalists may not like it, but it’s true – today’s oil and gas prices are a testament to how vulnerable some of those supplies are. We need natural gas to heat homes, keep the lights on, and charge electric car batteries. Gasoline is still essential for most cars on the road, jet fuel is how our planes stay in the air, and plastics are still essential in devices we use every day. We just don’t have viable alternatives at scale.
Given the need is very real – who better to do the drilling and extracting than today’s big energy companies? We should be supporting them, investing in them, and helping them thrive. Think about it – we’re talking about essential goods with potentially high profit margins. At oil prices near $100 a barrel someone is going to go out into the world and pump some oil. Doesn’t matter how strongly you feel about the environment – the reality is that someone is going to pump at those kinds of prices.
If you’re a conservationist then the real discussion needs to be about who do you prefer to be running the oil operations? An underfunded private operation with no governmental oversight or accountability, a group that’s cutting corners to try to squeeze out every last bit of profit they can? Or would you rather someone like Exxon or Chevron CVX do it?
Big oil has decades of experience in complex operational excellence. They’re heavily scrutinized by government regulatory agencies. They have large balance sheets to pay for rehabilitation or clean up in the rare case that they do have an accident on site. They are large institutions who you can hold accountable and have been facing withering criticism from the general public and from capital markets for their environmental stances over the past decade.
In short, if you have to pump oil, they’re the kinds of groups who you want doing it.
Plus, lets look at the positive externalities if big US energy companies are the ones who are filling the supply gaps for fossil fuels. They’re based in the US so the profits are taxed and distributed here. They create jobs here. And beyond that, because of the pressure ESG groups have put on big energy over the past decades, a lot of the profits are now reinvested into research and development of alternative energy supplies.
In particular we would call out energy companies as likely leaders in carbon sequestration efforts. Energy companies have operational expertise in the drilling, injecting, and monitoring of various geological formations. They have significant human capital advantages and large equipment stockpiles – these give the companies a natural advantage over other entrants into the space.
Similarly, energy companies who currently focus on the transportation and storage of fossil fuels are a natural fit for future technologies like hydrogen. Expertise in refining, compression, and transportation of complex substances is hard to come by. Refining and middle market transportation firms are in the sweet spot to leverage expertise and existing infrastructure, retooled for a renewable era.
Energy Market Dynamics:
Energy companies are also looking attractive from a more structural perspective. Oil production globally has struggled to keep up with demand as a number of different factors have impacted investment and production. The Russian invasion of Ukraine is the obvious disruption – Russia provided a significant portion of European natural gas and oil. But Russian aggression isn’t the only issue – if the war ended tomorrow and sanctions were lifted, the world would probably still face tight energy markets.
There are three primary factors for this more structural issue.
First, Russia is not the only country whose supplies have been disrupted by violence or corruption. Several other significant energy producers have also struggled politically in the past several years and seen their production dwindle. Venezuela and Libya are two prime examples, and Nigeria is rapidly seeing its energy production drop even as it steps up the import of refined products. Individually one country struggling with production isn’t that impactful, but over the past several years we’ve seen millions of barrels a day of production exit the market due to geopolitical tensions or mismanagement.
Second, and perhaps most important, we’ve seen a broad based underinvestment in energy over the past several years. Part of this is political realignment towards renewables, part of this is driven by more ESG sensitive public markets, and part of this is a decades long shift in how energy companies deploy capital. The cumulative impact is significant though; we haven’t seen a new refinery built in the United States in a very long time. Pipelines to transport oil and gas have faced significant construction barriers despite being significantly safer than truck or train transportation. Exploration and reserve expansion has also declined.
Third, the technology used to extract oil has changed. The shift from traditional drilling to shale has significantly shortened the investment cycle. Shale well production is heavily weighted towards the first 12 to 24 months. In order to maintain the same oil output, you need to constantly be drilling new wells and reinvesting capital. While this is good for individual oil companies – they can each be more cautious with how they invest and react to the markets and their own capital situation – it makes the overall market supply more volatile as there are fewer constant or base load barrels being produced.
Caveats And Investing:
Combine all the above factors and it paints a fairly attractive picture for the energy sector as a whole. It’s a strategically essential sector with attractive structural supply and demand dynamics.
However, it is worth noting that the energy space is exceptionally volatile and the space can change rapidly. The world is likely approaching a recession if we are not already in one, and geopolitics can move quickly. Structural support for a space may not be enough to overcome the cyclicality of the sector. What that means is that if you’re looking at investing in the space, you probably want to stick to the big companies – Chevron, Exxon, and the other oil majors. They have the strongest balance sheets, can weather a downturn, and, focusing on the environment again, they have strong corporate governance and deep research budgets.
