Feature interview
Tristan R. Brown is an energy market expert, lawyer, assistant professor, and long-time Seeking Alpha contributor. His work has been covered by major media outlets such as The New Yorker, US News & World Report, and Newsweek. We emailed Tristan about the shift in the approach of major integrated O&G companies towards renewable energy, divestment campaigns, and how to identify mispricings in the energy sector.
Seeking Alpha: What underappreciated or overhyped trends do you see in the energy market that investors can take advantage of?
Tristan R. Brown: Energy investors can often be too far-sighted in terms of quantifying the impacts that new trends are likely to have on the energy sector. Before the Great Recession, for example, the markets became very concerned about "peak oil" and an imminent decline in global oil and natural gas output. Many of the alternative energy investments that were favored at the time incurred large losses when energy prices declined in late 2008 and early 2009. Today, I see a similar trend in the markets, only now "peak demand" has replaced peak oil as a major worry. The declining costs of electric vehicles and renewable electricity certainly pose a long-term threat to oil and gas demand, especially when considered in conjunction with global efforts to reduce greenhouse gas emissions. The notion that oil should be trading below $20/bbl (and oil producers at comparable valuations) is overstated, though, especially given the world's continued heavy reliance on refined products other than gasoline. The market's over-eagerness to subscribe to the peak demand concept in early 2016 created an excellent buying opportunity, for example.
SA: What is your outlook for the biofuels market/policy? Which refiners and producers are most levered to any changes in policy and/or RIN prices?
TRB: I am skeptical of the notion that the revised Renewable Fuel Standard (RFS2) biofuel blending mandate will be discarded or heavily modified anytime soon. Reports of its demise have not been borne out on numerous occasions since 2013's "RINsanity" episode due to strong support for the mandate in the politically-influential Midwestern states and general dysfunction in Congress. That said, the mandate's opponents have long-since discovered that they can temporarily talk the program's costs lower to the broad benefit of merchant refiners' share prices, but especially those that have been the most affected by high compliance expenditures in the past (specifically CVR Refining, PBF Energy, and Valero). The share prices of major biofuel producers, on the other hand, such as Green Plains, Inc. (GPRE), Pacific Ethanol (PEIX), and Renewable Energy Group (REGI) fare well when the federal government inevitably restates its support for the mandate in its existing form every November.
SA: How do long-term (but ongoing) factors such as climate change play into your current investment decision-making process?
TRB: Climate change is very tricky to incorporate into investment decision-making due to the high amount of uncertainty that surrounds its specific impacts (as opposed to the very low amount of uncertainty that surrounds its existence). Where I do take it into account, however, is when considering the impacts of climate policy on specific sectors. My long-term outlook for natural gas is bullish since gas-fired power plants represent one of the lowest-cost methods of reducing greenhouse gas emissions in developed countries, both by replacing coal-fired capacity and providing a backup to the intermittency of low-cost renewables such as onshore wind. I am bearish on coal's long-term outlook for the same reason, especially as major consumers such as China make plans to reduce their use of the fuel.
SA: Can you discuss how major integrated O&G companies are orienting more towards renewable energy? Which ones are farthest along? What challenges do they face? How long until renewables are a meaningful portion of revenue?
TRB: The market has seen a large shift in the approach that major integrated O&G companies have taken toward renewable energy over the last decade. Before the Great Recession companies such as BP were making substantial investments in rather novel pathways such as microalgae and cellulosic biofuels due to the high price of oil. Most of these investments dried up after oil prices fell in late 2008. The most recent wave of investments by companies such as Exxon Mobil (XOM) and Royal Dutch Shell (RDS.A) (RDS.B) have occurred or been maintained during a time of relatively inexpensive energy. While the interest in diversifying their energy sources remains the same as before, the driving factor is a recognition that the long-term global outlook for oil demand is weakening due to fuel efficiency, technological change, and climate policy. Even then the companies are taking different approaches, however: Exxon Mobil has largely focused on renewable fuels (i.e., its joint venture on microalgae with Synthetic Genomics) while Shell has been investing in renewable electricity capacity. The challenge to the former's work is overcoming millions of years of evolution, although last summer's announcement that the JV had solved the problem of the so-called "lipid trigger" represented a critically important milestone in this regard. The challenge to the latter's investments is largely financial rather than biological given that renewable electricity capacity continues to be more expensive than gas- and coal-fired capacity in most places on a levelized basis (although renewables are rapidly approaching cost parity in many regions such as the U.S. Midwest and southern California).
The question of revenues is more difficult. Assuming continued progress by Exxon Mobil and Synthetic Genomics, I would expect to see large volumes of algae-derived fuels being produced by 2025. The challenge with renewable electricity is that electricity has a much lower market value than energy-dense fuels such as oil, so oil prices will need to fall sharply even as renewable electricity capacity is rapidly increased before I would expect to see the latter show up as a notable revenue source for a major integrated O&G company.
SA: What do you think about divestment campaigns in terms of their overall effectiveness? Do they create any opportunities for contrarian investors to go long?
TRB: Today's fossil fuel divestment campaigns are largely ineffective at achieving their goals because of the simple reason that energy-dense fossil fuels will experience strong demand for the foreseeable future, especially as developing countries grow wealthier. All that these campaigns do, then, is cause the target companies to be more undervalued than they would be otherwise. In theory, the campaigns could create long opportunities for contrarian investors, but in practice, they simply have not been effective enough to drive market sentiment (without which long investors in those firms cannot, by definition, be contrarian). O&G producers, in particular, are not a niche market, and divestment campaigns will be ineffective so long as people rely heavily upon diesel fuel, jet fuel, asphalt, plastics, and other critical fossil products.
SA: How do you identify mispricings in the energy sector on the long or short side? What are the typical catalysts to close the discount to intrinsic value? Can you give an example or two?
TRB: I like to look for opportunities that are created when the market misidentifies a short-term event as a long-term trend. Two examples come to mind. In late Q3 2013, I argued that the ethanol producer Biofuel Energy was very overvalued due to overcapacity in the ethanol market that had been created by a multi-year trend toward reduced gasoline consumption (ethanol consumption largely stays below 10% by volume of gasoline consumption). The company was experiencing cash-flow issues at the time but, in part because of the high oil prices that prevailed then, the market had assumed that these would be temporary. The company's response later that year was to sell its ethanol facilities and, because of the overcapacity that existed, the sale price was much lower than the market had assumed it would be, causing the company's share price to fall sharply.
On the long side, in late 2014 ethanol producer Green Plains saw its share price sink as oil prices fell by more than 50%. The market's assumption was that cheap energy was the "new normal", but I argued that the biofuels mandate would provide it with a financial backstop until energy prices rebounded. Sure enough, the company's share price gained 50% in the first five months of 2015 as a particularly strong summer driving season created such a rebound.
Of course, sometimes I am the one to misidentify events. My most disappointing long call has been Renewable Energy Group, a major biodiesel producer. Biodiesel has a very small carbon footprint compared to its fossil fuel counterpart, and in August 2013 I argued that the Obama administration would mandate increased biodiesel consumption as part of the biofuels mandate as a means of meeting greenhouse gas emission reduction targets without relying on the politically-controversial corn ethanol consumption. In the end, the Obama administration did just that, but my prediction was off by three years and Renewable Energy Group continues to trade near its August 2013 share price. Accurately predicting the timing of an event can be more important than predicting the occurrence of the event itself.
SA: What's one of your highest conviction ideas right now?
TRB: I believe that the recent sell-off in the share prices of major integrated O&G producers is overdone. The price of oil has rebounded strongly from its early 2015 and early 2016 levels and, while domestic oil consumption appears to be plateauing, the upstream economics are more attractive than they have been in some time. Refining economics are also looking strong, albeit not as strong as they were after Hurricane Harvey took out a large amount of Gulf capacity last autumn. U.S. renewable capacity continues to expand at a rapid pace as well, increasing domestic demand for natural gas (especially at current prices). Recent turmoil in the broader markets, especially concerns over international trade policy, have caused the share prices of the larger integrated firms, in particular, to lag despite a steady drumbeat of solid earnings over recent quarters. That turmoil will calm down, though, at which point I would expect share prices to rebound given current crude prices. A faster catalyst would be some sort of geopolitical event (especially something arising out of Syria or Yemen given the involvement of major oil-producing countries on different sides of those unfortunate conflicts) causing international crude prices to turn higher. Decent dividend yields while waiting for a positive catalyst are an added benefit.
My preferred vehicle for gaining long exposure to the major integrated O&G producers is the SPDR ETF (NYSEARCA:XLE) due to the security provided by diversification. Investors who are concerned about the long-term impacts of climate policy should consider two of the firms mentioned above, Exxon Mobil and Royal Dutch Shell, due to the growing addition of renewable energy to their product mixes (first-mover advantage in the case of Exxon Mobil and capacity in the case of Shell).
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Thanks to Tristan for the interview. If you'd like to check out or follow his work, you can find the profile here.
