Energy is Transitioning to Renewables
The global economy is transforming away from carbon fuel sources. In this period of transition, it is often easier to identify the losers than the beneficiaries. From a big picture perspective, the following points are pertinent:
1) The US shale algorithm is broken – whilst the United States is currently the largest oil producer in the world, production may have peaked. Moreover, there is intense pressure on banks against funding energy producers. Winning back shareholders is going to be highly challenging given the historical prioritisation of growth over return on capital by management teams. The capital structures of many incumbent shale operators are heavily loaded with debt. Given the US high yield energy index is back to 2008 and 2016 levels, it suggests the cost of capital may remain elevated for quite some time. Whilst the government may provide short-term support, capital markets are effectively closed for the shale players.
2) Pressure on the oil and gas sector has been intensified by institutional investors pursuing an ESG agenda and thereby shunning carbon emitters. This is a broad-based movement, particularly vibrant in Europe, and is not reversing. A win by the Democrats could mark the next leg down in the sector by heralding the introduction of a carbon tax.
3) Given the inherent safety issues and lack of scale potential with nuclear energy, the future lies in a transition to renewable energy.
4) Electricity is gaining market share as it is more flexible and links to the electric auto revolution. Russia, Saudi Arabia and a couple of African countries are the last sole users of oil for power production.
Why this Cycle may be Different
Given it could take 24 months for energy demand to recover, E&P operators are responding aggressively. We have seen a flurry of capex cuts in 2020, with global spend expected to fall by 17%, according to Rystad Energy. Spend is likely to contract more heavily in the United States. As inventories mount, the least fit producers will engage in capital restructuring, which will likely involve some filing for Chapter 11. As such, we may see a fast rebalancing since the shale sector is under such intense pressure. Whilst this may appear to bode positively for the sector, I do not expect Shell (RDS.A) (RDS.B) or the other majors to generate considerable free cash flow for shareholders. Instead, I believe Shell’s management team is going to spend heavily on renewables.
Whilst some may think we could see an oil and gas mega-merger wave, I believe they may be disappointed at least in the short/medium term. Listening to energy majors' earnings calls over the last couple of weeks suggest management teams are prioritising the deployment of capital in the renewable energy sector. Where we could see the direction of travel for M&A is towards acquiring utilities or renewable power producers. In 2018, Total (TOT) acquired Direct Energie, a French electric utility. This followed their 2016 acquisition of Saft, a battery maker for $1.1bn. The company plans to start producing EV batteries by 2023.
Shell’s Dividend Cut is Instructive
When Shell announced a cut in its dividend on 30 April for the for the first time since World War II, what was most striking was the severity of the reduction – a 70% cut which caught investors off guard and illustrates the existential crisis unfolding within board rooms. I believe the move underscores the transition to a new era. The prevailing yield is now 3.5% and could mark a major step towards re-positioning the business towards a renewable-focused business. Those expecting the dividend to be hiked if oil markets recover may be left disappointed. Instead, management could be on the hunt to acquire a utility or invest directly in renewable projects.
The Good News
The good news is that renewables are increasingly becoming the lowest cost mechanism of providing energy and households are beginning to embrace the transition to electrification of transport and reduction in plastics, which also affects oil demand.
According to Renewable Energy World, renewable power accounted for 18.5% of US electrical generation in the first 8 months of 2019. By 2060, this could flip-flop with renewables accounting for around 80% of power generation.
Even airlines are becoming more environmentally friendly. The French finance minister recently signalled their intent to save Air France but on the condition the airline becomes the most environmentally friendly airline in the world.
The Bad News
The bad news for the oil majors is they are relatively late to the party. Existing renewable players such as Vestas (OTCPK:VWDRY) (OTCPK:VWSYF), NextEra (NEE), and Canadian Solar (CSIQ) have already gained a significant footprint and offer investors a pure-play exposure to renewables. As the big oil majors enter the renewable space, returns on capital are likely to disappoint given strong competition for capital from new and incumbent operators.
We are at the beginning of a 20-30 year growth theme in which transportation infrastructure transitions towards electro mobility. As wind/solar penetration increases and hydrocarbon usage declines, renewable specialists such as Vestas or NextEra are ideally positioned in to benefit. Whilst there is the potential for some projects to be delayed from 2020 to 2021 due to the social distancing measures enforced by governments worldwide, this is a minor blip versus the bigger picture. With traditional and gas majors pivoting to join the renewable energy revolution, I expect returns on capital to be unexciting and far lower than those enjoyed during the heyday of the fossil fuel era.