Tom Lyons, Head of Climate Investment Research and Senior Investment Analyst with Wells Fargo Asset Management, discusses climate change as it relates to integrated energy and the investment case for that sector.
Laurie King: I’m Laurie King, and you are listening to On the Trading Desk®. Today our discussion features highlights from a recent Investment Perspectives created by Wells Fargo Asset Management. It’s called The aspirational case for integrated energy.
I’m talking with one of the papers’ authors, Tom Lyons, Head of Climate Investment Research and Senior Investment Analyst with Wells Fargo Asset Management. He’s been our guest before, discussing the auto industry and global utilities in the context of climate change.
Today we’ll be talking about the third topic in this series, integrated energy. Welcome back to the program, Tom.
Tom Lyons: Thanks, Laurie. It’s great to be back.
Laurie: So this is the third sector in a series that the Climate Change Working Group has addressed. How did you choose to delve into the aspirational investment case for integrated energy?
Tom: The Climate Change Working Group constantly focuses on the energy sector broadly defined, which should be no surprise, given how carbon intensive it is and how essential it is to the global economy. So it’s been a long-standing topic of discussion for the team.
However, the topic has become all the more urgent recently for a couple reasons.
The first is that the stock market and bond market performance of energy firms, generally speaking, including integrated energy firms operating across the value chain—upstream, midstream, and downstream—has been so challenged that the attention we were getting from our clients and our investment teams internally was rising to quite a high level.
So we took a step back and reexamined the sector and noticed first and foremost that the sector hasn’t only been underperforming over the last few months. It’s actually underperformed the market over 3-, 5-, and 10-year horizons. So that begs the question as to why, and we thought it would be important to go back to take a fresh look at the sector and better understand the role that climate change plays in explaining the sector’s performance.
Laurie: Let me ask you again about the title. The word choice I find interesting: “aspirational investment case for integrated energy.” Why did you choose that word?
Tom: Yes, thanks for asking that question, Laurie. It’s really important one.
When our energy analysts across our equity and credit teams sat down to have a look at the sector, two things really occurred to us.
The first is that the sector’s doing a lot more to respond to some of the challenges they’d suffered from over the last 10 years that we think most investors appreciate, but also we think investors are skeptical for good reason.
This sector has not done a good job at embracing new technologies, especially clean energy technologies, over the last several decades. And further, the sector has not always handled the markets environmental concerns as well as it might have.
If we layer in the market skepticism and doubt about the energy firms’ ability to succeed in clean energy and look at what that means for the way the companies are valued and the amount of credit that the firms will be given by the market, even when energy companies are announcing new business initiatives, we have to acknowledge that it’s going to take a while, both for the firms to show success and for the energy firms to regain the confidence of the market, and we think only several years of success will allow them to succeed in the mind of investors.
So to summarize, we simultaneously see a lot of potential value that the sector can create, but we acknowledge that there’s execution risk and there’s a lot of winning over of investors that’s going to need to happen before that value is properly reflected in equity and credit markets.
Laurie: So as you said, looking at the historical investment performance of the energy sector, it has been the worst-performing sector in the S&P 500 Index over 3-, 5-, and 10-year periods. What happened?
Tom: This is the first question that the analyst team and I sat down to have a look at as we refreshed our view of the fundamentals of integrated energy sector.
The view we developed was that four factors in particular were most important in driving underperformance over these various investment horizons.
The first of those four factors was the end of the commodity supercycle, and this was driven mainly by China’s meteoric growth through the 1990s and 2000s, and then moderation in growth as we work closer to the financial crisis, and also the way the market quickly responded by adding supply at the same time as China’s growth rates were moderating for demand in oil products. But as China’s growth moderated and as the supply response became more pronounced and more cost-efficient, prices crashed far below production cost for a period of time and led to the distress—financial distress—of many firms. So really when we think about underperformance, that’s probably, if not the most defining factor, certainly one of the most important factors that have driven the underperformance over the last 20 years.
The second event that we looked at was really part of the first and that is the advent of shale and other unconventional oil and gas production. In fact, without the hundred dollar-per-barrel range of oil prices that we saw at the peak of that cycle, it’s unlikely that shale could have become economic at all, at least in small scale. It’s unlikely it would have been able to expand and achieve the sorts of economies and efficiencies that it did, and it’s also unlikely that the additional technological improvement would have taken place as quickly as it did.
So in other words, without the extremely high oil prices that we saw in the 2000s, it’s unlikely that shale would play the important role it plays today in global oil and gas markets. We should also point out that shale also flattened the supply curve for oil by quite a bit. That is, with the reduced slope of the supply curve, the average producer makes thinner margins than it would otherwise do relative to the marginal producer. So in addition to low prices in an absolute sense, the compressed margins that went along with the flatter supply curve were really an important part of it initially.
The third factor hitting closer to home for our climate team is the energy transition. At the same time as oil and gas’s traditional business was facing fundamental pressure, markets began to really start to question future demand trends for oil and gas over shorter and longer periods of time. The growth of renewables and power generation, the expansion of electric transportation, the increased prevalence of home heating and cooling, and the expectation for all of those trends to continue started to eat into forecast demand for oil and gas profitability into the future. So energy transition was and remains an important part of the market’s outlook on integrated energy.
Fourth, very important as well, is strain beginning to develop on oil and gas’s social contract. It’s well known that the energy sector’s been criticized on several occasions for the way in which it managed or mismanaged societal concerns around carbon emissions and environmental impacts, more broadly. There has been an equally high level of concern, at least amongst our analysts internally, about energy from corporate governance across ESG factors.
This isn’t limited only to environmental and community-oriented concerns. Primary amongst the list of governance concerns that we talk with our analysts about had to do with compensation practices and capital budgeting. Clearly, it’s been widely reported that several executives earned quite a bit of money throughout the last 5 to 7 years, despite the fact that their companies, in many cases, were performing poorly and in some cases failing.
So each of these factors plays into the level of trust and understanding that the global community and the markets, in particular, have with the integrated energy firms and some level of deterioration of the quality of that relationship, we believe, was another important part of the explanation as to why the companies underperformed.
Laurie: So it makes me think back to your title of The aspirational investment case. It almost seems like you’ve outlined these reasons for underperformance, so what are firms doing to respond? How are the climate risks affecting integrated energy firms’ actions?
Tom: If you look across the integrated energy sector and take inventory of what firms are doing to improve their value proposition, three strategies in particular come to the forefront.
First and most important, the firms are establishing much more convincing long-term strategies to succeed in a decarbonizing economy. If we look at the world of Shell, if we look at BP, if we look at Ecuador, across the value chain, the orientation towards clean energy and decarbonization is become extremely tangible.
Each of the firms I just mentioned has some aspiration related to net zero emissions over the next several decades. Each of them also—upstream, midstream, and downstream—are taking specific steps to reorient themselves to make money in clean energy in addition to just the traditional fossil fuel businesses. Renewable power generation is a big part of this. It’s common to all three, but also if we look at midstream infrastructure, there’s much more focus on hydrogen as a source of transportation fuel. And if we look at refining biofuels, they’re becoming much more prevalent across firms, and downstream, we’re seeing much greater participation by the integrateds in supply and retail in clean energy, providing infrastructure to charge electric vehicles and activities like this. So long-term strategies, consistent with a decarbonizing economy and establishing as core business propositions activities across the clean energy value chain, are becoming much more common and clear.
It’s not the case across the board, of course. Some of the firms are much more ambitious when it comes to decarbonization and clean energy than others. For example, two of the American firms, Exxon/Mobil and Chevron, have chosen very specific parts of the decarbonization process and energy transition events—for example, carbon capture and storage, in some cases, certain biofuels—but haven’t adopted in the much broader nature as their European competitors have done. Establishing clean energy is a primary core business.
That said, the impact is being seen pretty much across the board in one way or another and this is a critical first step in helping the companies improve their valuations of various markets in equity and credit.
Second, we’re seeing, I would say very commonly, stronger corporate governance practices. This is mainly related to the capital allocation and compensation issues that we discussed a minute ago, but it also has to do with managing some of the physical risks and transition risks related to energy transition. Firms are really getting on top of corporate governance as it relates to these market practices, and investors are beginning to take notice.
Third and finally, if we look beyond the corporate governance—and it’s important to both shareholders and credit investors—we’re seeing the firms reach out to really all stakeholder groups in an attempt to build a stronger dialogue. Here, we’re thinking, in particular, relationships with different governments for whom energy security is extremely important and for whom decarbonization is becoming extremely important, as well. We’re seeing a more vibrant dialogue with the various communities in which the energy companies operate and more concrete efforts to try and accomplish a win-win sort of relationship with them as both traditional and clean energy operations expand.
So more convincing long-term strategies, stronger corporate governance practices, and redoubling stakeholder relations initiatives, I think, are the three most noticeable responses that the energy firms are having.
Laurie: Well, thank you for that. How do you think firms’ choices will affect their value in both the equity and credit markets?
Tom: In our analysis, to begin to answer this question, we imagined an integrated energy firm that had successfully aligned its business, governance, and stakeholder strategies and taking all of its constituencies’ objectives in mind and asked: How much value can these actions create for the firm in credit and equity markets?
The analysis we followed up with suggested to us that the potential value is quite substantial. Now to be clear, there’s a lot of execution risk. Many of these firms are only starting to align each of the different activity sets that we just mentioned.
However, if we look at scenarios where the oil and gas firms continue to put time and effort into these sort of improvements and start to deliver and rebuild confidence amongst their investor base, we do think there are several scenarios in which substantial outperformance is possible in equity and credit.
So the premise really is that prevailing valuation methodology today doesn’t really capture clean energy value to the extent it might after a few years of success in adapting their operations.
Now there’s an important reason that our analysis is based on here and that is until recently, integrated energy firms’ clean energy activities really didn’t have much impact on analysts’ estimates of value. The most important reason is that clean energy business were very small relative to fossil fuel operations.
But firms have begun to invest increasingly large sums of money in clean energy, and some analysts’ estimate that clean energy as a percentage of overall capital expenditures could rise to more than 25% by 2021 or 2022. And that’s up from 15% in 2014. This would make clean energy capital expenditure larger than upstream oil and gas capex for the first time in history.
In our view, the rise in prominence of clean energy is yet to be fully reflected in credit and equity security values with this in mind. We provide detail on how changing valuation methodology in the market—that is differentiated treatment of both the higher growth rate for clean energy and lower risk profile for clean energy—can really drive the kind of difference we’re describing here.
Laurie: Before we close, can you tell our listeners what’s next for the Climate Change Working Group?
Tom: Absolutely. Our team, which meets every Friday, continues to establish coverage across the various sectors of the economy.
So far, we’ve covered most of the industrials with particular focus on energy, utilities, and autos.
Going forward, throughout the rest of this calendar year, we’re going to spend our time focusing on financials. We’re well into an analysis of the insurance firms that take direct exposure to the physical climate risks that we’ve talked about in these podcasts in the past.
We’re also starting to cover money center banks who represent roughly 40% of the investment-grade credit index, so the financials analysis is a very different analysis than it is for industrials. We’re drawing in input from our equity and credit investment teams in Europe and the United States and we’re getting into some really exciting ideas about how climate change is going to change the value proposition for both insurance companies and banks.
So we’ll look forward to sharing that with our clients in a published note and we’ll look forward to coming back, hopefully Laurie, and speaking to you more about that.
Laurie: I would love it. That does sound really interesting. We appreciate the time that you’ve taken to provide a perspective on climate change and how integrated energy companies are pivoting to address the challenge. Thank you again for joining us On the Trading Desk, Tom.
Tom: Thanks, Laurie.
Laurie: For our listeners, you can find our Investment Perspectives about climate change and sustainability by visiting http://on.wf.com/6129GaCMZ. To stay connected to On the Trading Desk and listen to both past and upcoming episodes of the program, you can subscribe to the podcast on iTunes, Stitcher, or Overcast. Until next time, I’m Laurie King; take care.
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