Oil: Transition And Transform

by: Henry Miles

Anxiety over sagging oil prices results from short-term thinking about an industry that calls for exactly the opposite, a long range view.

If you're so inclined, take today's opportunity as I have for a little mean reversion investing recognizing it for what it is, tactical.

However, my primary focus is strategic on the transition from oil to natural gas and the transformation to clean/renewable energy.

I do get a chuckle these days from all the oil price arm-waving such as Russia will suffer; when haven't they suffered, czars through the oligarchs? Or, what about this one, that cheaper fill-ups will lead to a boost in holiday spending never mind that prices at the pump are the highest they’ve been in four years. Or the insight in this revelation – the tar sands aren’t as economic when oil prices are low; who would’ve thunk it. And, my personal favorite that Trump “snookered” the Saudis into turning on the taps and trashing prices; I always thought they were smarter than that.

Reversion Is Not A Strategy

Mind you, I have done well in down commodity markets with mean reversion investing. In oil, this dates to 2016 when West Texas Intermediate and Brent were tracking closely together in the $30s and I took the occasion to buy British Petroleum (BP), Royal Dutch Shell (RDS.A) (RDS.B), and formerly French Petroleum, now Total (TOT). Just recently, SA author, Daniel Jones, alerted us to the current opportunity with WTI back near $50 a barrel and Brent under $60. So, on Friday, I added 20% to each of our three positions and, for good measure, then bought another 1,000 shares of BP.

I consider reversion investing to be tactical for two reasons: a) technical analysis, not fundamentals or insight, signals the moment when the price of whatever drops below its historical average, and b) such opportunities are generally short-lived as we may have begun to see within the last 48 hours with the price of oil bouncing back above its mean. There is nothing wrong with reversion investing (especially if you're an algo trader), but it should be recognized for what it is.

What it is not, is grounded in longer term, strategic thinking that is called for with regards to energy. Specifically, there is a secular change underway in the transition from dirty coal/oil to natural gas, and in the transformation to clean/renewable energy including solar, wind, geothermal, hydrogen and even tidal. Those committed narrowly to oil will be overtaken in time just as we’ve seen with coal.

According to the IEA, every major country except India reduced its consumption of rock carbon last year. Oil use isn’t that far behind. BP and Royal Dutch Shell, respectively, estimate that demand will peak in the late 2020s to mid-2030 with the IEA’s projection being somewhat later than that. Indeed, just recently, the IEA forecast that solar photovoltaic energy will outshine all but natgas by 2040.

The Transition To Natural Gas

So why now, other than reversion investing, am I interested in British Petroleum, Royal Dutch Shell, and Total? Because, in addition to being major integrated oil companies: a) they make the top ten list in natural gas, and b) more than the other majors, they are beginning to “walk the talk” of renewable energy. As to natgas, just three recent developments:

  • British Petroleum is expanding its fleet of tankers and facilities to support its LNG interests in response to growing demand for that lower-carbon energy source.
  • Royal Dutch Shell and its partners recently announced investment in a $31 billion LNG project in Western Canada that will supply China, now the largest importer of natural gas.
  • Total discovered a field off the Shetland islands that is estimated to hold 1 trillion cubic feet of natural gas.

I’ve lost track of when big oil began to feign concern about the environment. However, it was somewhere before the turn of the millennium after British Petroleum acquired Amoco. Concurrently, they changed their name to “BP Amoco,” later shortened to “BP.” And, soon thereafter they launched their “Beyond Petroleum” public relations campaign. Putting aside the joke at the time that BP really meant “Burning the Planet,” I resonated to their clean, green, fresh, graphic design. It began to differentiate the company from its competitors while setting a tone for the future. Memories were still fresh of Exxon (XOM) Valdez.

The Transformation To Renewables

Sadly, “Beyond Petroleum” came to be viewed as an epic PR failure. Open minds were slammed shut in 2010 with the Deepwater Horizon disaster. The loss of life, environmental destruction, and socioeconomic impact were unprecedented as reported by NOAA and many others. With the benefit of hindsight, though, perhaps Macondo was a turning point. Since then, the volume of spills has almost flat-lined while some in the industry began to shift their attention toward cleaner fuel where these three majors have begun to set themselves apart:

  • British Petroleum is pushing into solar and wind. They have interests in various wind projects and earlier this year formed a strategic alliance with Lightsource (private) for the development, acquisition, and management of large-scale solar projects throughout the world.
  • Royal Dutch Shell is expanding organically and through acquisition to deliver electricity, and even hydrogen at the pump. It’s an interesting strategy no doubt aimed at building and leveraging their retail distribution network.
  • Total, the most aggressive major in renewables, has a controlling stake in SunPower (SPWR) with intentions to dominate that business in France and Japan. Given France’s deep ties in the Middle East, it’s possible that Total will also help develop solar power there. Also, Total and Petrobras (PBR) recently announced what appears to be a significant renewables/solar collaboration in Brazil. And, like Shell, Total is moving to rapidly extend its electric charging network including with its acquisition of G2mobility.

Reasonable investors can disagree with my perspective on these companies' commitment to renewables. However, it’s becoming increasingly problematic to argue that the future of the oil industry is not embodied in the transition to natural gas/LNG and the transformation to renewables. Beyond our oil majors of choice, here’s a quick update on our other clean energy holdings:

  1. Converters of power – Leaders in their markets including fuel cells/Ballard Power Systems (BLDP), solar/First Solar (FSLR), geothermal/Ormat Technologies (ORA), and wind/Orsted (OTCPK:DNNGY). I still haven’t found a pure play in tidal energy but I’m keeping my eyes open as with Nova Innovation, if only it were public.
  2. Battery storage – ABB (ABB) and AES (AES). While ABB appears to be backing away from the grid business, they are very much committed to batteries as represented by their partnership with NorthVolt to build the largest such production facility in the EU.
  3. Grid development – Siemens (OTCPK:SIEGY) is also active in wind via Gamesa (OTCPK:GCTAY) and various solar micro-grid initiatives. As I've written about in the past, I suspect the company is positioning to become a/the global renewable energy integrator.
  4. Utility companies – Engie (OTCPK:ENGIY) last week announced a financing/investment partnership with Goldman Sachs (GS) that will open the way for distributed solar and battery projects throughout the U.S.
  5. Appliances/automobiles – Were it not for their higher leverage, I would be an investor in Volkswagen (OTCPK:VWAGY) that recently announced a $50 billion investment to develop EVs; watch out Tesla (TSLA). As it is, our money is on Toyota (TM) that is also pushing forward in that space as well as innovating with respect to hydrogen fuel cells (don’t scoff).

The political climate may become more favorable for such companies. A few years of extremely anomalous melts, floods, tides, hurricanes, and fires helps focus attention such that the U.S. may finally be ready to join the rest of the world in addressing issues embodied in the Paris Climate Accord. Moreover, with the House of Representatives in charge of writing spending legislation and the resounding midterm victory by progressive/activist democrats, I could envision the president beginning to accept some infrastructure investments and other measures to slow human-contributed global warming. Notwithstanding his posturing, hopefully this is more likely given last Friday's U.S. government assessment – in this case, as reported by Fox St. Louis – about the consequences of not addressing climate change; very concerning.

While we wait for federal action, investors should look to states and other countries for leadership in renewable energy. California is leading in the U.S. on nascent technologies such as hydrogen fuel cells. Scotland is out front on tidal energy; Denmark on wind. Indeed, the EU is getting behind plans to be "climate neutral," net-zero emissions, by 2050.

A continent away, China is also pushing forward on a number of fronts. As but one example, their efforts to reduce smog made palladium 2018’s best-performing metal (our ADRs in Anglo American Platinum (OTCPK:ANGPY), also one of the world’s largest palladium miners and recyclers, are doing nicely). In other words, care for the environment is now progressing from a series of short jogs to serious intra- and inter- national long-distance races. All this means investment, and a lot of it.

As For A Few Financials

As for numbers, I’ll forego a discussion of British Petroleum, Royal Dutch Shell and Total. They are all rock-solid right through their P&Ls, cash flow statements, and balance sheets with strong coverage ratios and dividends well in excess of the 2% one can earn on the average S&P 500 stock.

The next tier of companies – including ABB, AES, Engie, Orsted, Siemens, and Toyota – all show some spottiness in their financials including with sales, earnings, leverage, liquidity, and so forth. Because I attribute much of this to “finding their way” in the new world of electricity/renewables, I’ve turned my attention to the news along the lines of the links I’ve embedded above.

I’m even more zeroed in on the news of the three smaller “converter” companies – Ballard, First Solar and Ormat. Even though they all have beachheads in their respective subsegment, they are high-risk investments. Yes, they have surmounted important learning curves, but they have not proven themselves financially especially with respect to revenue consistency. Therefore, we only maintain partial positions in these stocks.

I do appreciate that they are all running with low leverage and high liquidity, two metrics important to early-to-growth stage companies. In addition, if necessary, all three represent good candidates for acquisition or recapitalization. (I’m not afraid of dilution; my dad who was a successful entrepreneur of companies that went public used to say, “I'd rather own less of something than more of nothing.”)

2017 Ballard First Solar Ormat
Total Debt to Equity 5.34% 8.27% 46.08%
Total Liabs. to Equity 48.33% 34.63% 116.60%
Current Ratio (w/Inv.) 2.52x 4.48x 1.06x
Quick Ratio (x/Inv.) 1.16x 4.14x 0.85x
Operating Cash Flow ($10 million) $1 million $246 million
Cash and Securities $60 million $3 billion $48 million

(Parenthetically as to overall portfolio strategy, because of market weakness and volatility, we now have one third of our financial assets in purchased money funds comprised of T-bills, Repos and other short-term holdings. Collectively, the ideas discussed above comprise another third of our holdings or about half of our equity book.

The remaining amount for us includes agribusiness, Boeing (BA), commodities, pharma, I/T/services, and water/waste management stocks. For another cut, our positions are split roughly 50:50 between U.S. stocks and listed shares or ADRs in foreign companies. This allocation has served us comparatively well this year, especially of late.)

Transition And Transform

It’s worth repeating, “transition and transform.” Transition insofar as natural gas will, over the medium term, continue to replace coal and oil as the fuel of choice for large scale power generation and various retail uses including, notably, business and home heating. Transform because, longer term, natgas will be pushed aside by renewables. Strategic investing.

Since oil was “discovered” 160 years ago, those involved with its extraction, refining, and delivery have accumulated enormous wealth. The companies mentioned in this article have combined equity approaching a trillion dollars. Add in all the other state-owned and public majors, together with everyone else in the fuel and power supply-chain, and the number is perhaps 10x that. In other words, there is a lot of capital to affect positive change.

That said, as it is with coal, many companies are destined to atrophy because they are fixated on oil and unable or unwilling to meet customer demands for a cleaner world. Object lesson: Peabody Energy (BTU) that is already back on its downward slide having emerged from bankruptcy not even two years ago. Other organizations will fall behind faster what for their entrapment in the past and/or their relative lack of talent, technology, capital, and other resources.

And, the failure to adapt will not only affect producers but will extend along the supply chain to refineries, pipelines, rolling stock manufacturers and others. Trinity Industries (TRN) is but one example of a partially fossil fuel-reliant company that must watch what’s coming up behind them.

Now, I well expect ridicule in the comment section below from both clean and dirty energy purists. The former will dismiss the very idea of natural gas as a transition fuel, and the latter will mock solar, wind, tidal, hydrogen, even clean. Bring it on, but remember that this website is about investing. Take advantage of short term, tactical reversion opportunities as you wish. But, remember that broader-thinking investors are strategic, looking to the future of energy in light of the challenges we face and the renewable movement that is undeniably underway and accelerating.

Disclosure: I am/we are long BP, RDS.B, TOT, BLDP, FSLR, ORA, ABB, AES, SIEGY, ENGIY, TM, ANGPY, BA. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Always do your own due diligence in consultation with a licensed and competent financial adviser who understands your unique needs and puts your interests ahead of their own. Remember, there are added considerations in owning foreign securities including those associated with ADR sponsorship, buying and selling the pinks, foreign withholding taxes on dividends, and fees. (All my proceeds from contributing to SA go to charity.)

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