Commodities | Sep 18 2020
The global pandemic hasn't been kind to the world's energy sector and companies need to adapt with industry dynamics changing irrevocably
-Covid-19 is forcing energy sector to restructure
-World’s energy mix is fundamentally changing over next 20 years
-Companies adopting sustainable practices expected to show better resilience
By Anastasia Santoreneos
The covid-19 pandemic has seriously disrupted the energy market, with demand for coal, oil and gas weakening significantly, but investment experts aren’t convinced it’s the end for fossil fuels entirely.
A recent Goldman Sachs equity report found that the oil and gas industry is restructuring through consolidation, capital efficiency and higher barrier to entry as investors push for both higher corporate returns and lower carbon intensity.
Unsurprisingly, the covid-19 pandemic has been a driving force behind the restructuring of fossil fuels, with lockdowns forcing transportation to effectively come to a full halt, according to head of research at Martin Currie Australia, Michael Slack.
“We have seen a contraction of energy demand during covid-19, with oil consultancy Rystad Energy estimating oil demand down -25mbopd in April 2020. It has since recovered to down -10mbopd,” points out Slack.
“The share prices of oil and gas companies fell dramatically in response to the falling oil price. We believe the price fell, and remains, at unsustainably low levels, which together with share price overreaction, caused us to increase our exposure to stocks related to the energy sector on the basis of value.”
While curbed transport was the main driver behind falling oil prices, Slack also cites an “opportunistic” move by Russia to withdraw from the OPEC cartel, to use the demand weakness to put pressure on the US shale industry. He also puts it down to the WTI oil price going negative due to the futures expiry and a lack of available storage.
ESG senior research analyst at Calvert Research and Management, John Miller, adds high fixed costs and limited operating ranges of coal-fired power were also major losers from the pandemic, as commercial and industrial demand for electricity declined.
Gas was slightly more resilient, but a global market that was already oversupplied led to production shut-ins and cancelled LNG cargos, says Miller.
A ‘broken’ structure rocks the future
As Miller recalls, investment performance in the oil and gas sector remains driven by the underlying commodity price of those hydrocarbons, which has historically followed regular cycles of boom and bust, defined by a perception (or reality) of over or under supply
“This structure is now broken,” he concludes.
Miller thinks changes in technology have boosted economically viable oil and gas reserves leading to a prolonged – or indefinite – market oversupply.
And it’s not good news on the demand side either.
“There’s too much demand uncertainty,” Miller suggests. “While less than linear, the core end markets for refined oil products, transportation and petrochemicals, are under stress as growth rates decline and plateau.”
Miller continues: These growth rates are exacerbated by government action to promote lower carbon alternatives as the spotlight rests on the existential risk to the sector.
“It has an enormous environmental footprint, there’s too much pollution,” he finds. “While this footprint is often considered simply in terms of environmental damage, its effect on human health via air pollution is equally vast.”
Martin Currie has a similar outlook, saying the energy mix is fundamentally changing over the next 20 years: “In this transition we see demand for fossil fuels, coal and oil, declining over the period,” Slack predicts, while explaining:
“We see this happening quicker in coal, as it can be readily displaced by renewables and gas, and more gradually in oil as transport transitions to electrification.
“We think, at the end of this period, there will still be a need for fossil fuels in the global energy mix, just less of it. So the issue on viability is how much fossil fuel resource is required to satisfy demand and where that demand intersects the cost curve. We therefore want exposure to low cost supply.”
Goldman Sachs’ outlook shaved nearly 20 years off the longevity of oil productions.
“Under-investment in oil, an increasing focus on returns, de-leveraging, free cash flow, operational efficiency and ongoing capital discipline are taking a toll on oil resource life,” the report states.
Gas is a different ballgame: as a transition fuel, demand may actually continue to grow over the next two decades as it, and renewables, displaces fossil fuels like coal and oil from the global energy mix.
“In this context, we see a need for new LNG supply,” Slack suggests.
“To enable this, however, we see that gas prices need to be higher to incentivise new supply. The overcapacity in 2020, some of which is associated with demand destruction due to covid-19 and some due to increased supply from decisions made four-five years ago, has caused the global LNG price to trade below incentive price levels. We see this balancing up over the next few years as a lack of new investment decisions over the past three years sees the market caught short.”
A fossil fuel-free industry
Consolidation in the oil and gas space will lead to the progressive exit of higher costs and higher emissions intensity producers, according to Miller. As the global economy continues to “decarbonise”, demand growth for oil will slow, then eventually stop after reaching peak demand.
Miller: “It is our view that in this environment, the largest, lowest cost producers, those which tend to be state owned operators, will increase their market share by expanding production, furthering the financial squeeze on high cost producers".
Slack adds lower carbon intensity and higher returns are not mutually exclusive concepts, so companies that are on the path to sustainable practices will show better resilience.
Slack: “We do not place undue precedence on a company’s past activities, we prefer companies who are moving towards a sustainable future, and we believe we can positively influence a company’s pathway to improve their sustainability practices through active ownership (engagement, proxy voting etc), which is embedded in our investment process".
AGL Energy ((AGL)) for example is one ASX-listed company Martin Currie believes is transitioning in a positive way.
Slack: “AGL acquired Macquarie Generation in September 2014, resulting in over 40% of its EBITDA being derived from coal powered electricity generation".
“But AGL is both a large user and producer of so-called ‘dirty’ coal, but it is also one of the largest developers of renewable energy streams. The company has stated that ‘starting in 2022 and ending by 2050', AGL is 'getting out of coal’, which we fully support.
“We continue to engage with the company on its transition and we see that its sustainability practises will directly and positively impact its potential financial returns.”
Where to from here?
Martin Currie's Slack is of the view that Australia’s energy mix can’t exist of renewables alone, and natural gas will have a role to play in the transition to a lower carbon future.
Slack: “As such, we do not advocate for a binary view on the exclusion of all fossil fuels right now".
“In our portfolio we invested in thermal coal substitutes such as New Zealand utilities, which generate largely renewable energy. This includes Contact Energy, which generates 80% of its power from geothermal and hydro.”
The firm is also invested in other natural gas producers like Woodside Petroleum ((WPL)).
“While Woodside Petroleum does have high carbon emissions, natural gas is a much lower carbon emitting fuel than coal or other fossil fuel alternatives for base load electricity generation, and we see that it can help to reduce the overall carbon intensity of electricity generation over time".
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