Reflecting on significant changes in the investment landscape since the Global Financial Crisis (or Great Recession in other parts of the world) of over a decade ago, oil, gas, coal and renewables are all key players in a dynamic and volatile energy landscape.
It is clear that the influence of the largest oil cartel in human history - OPEC - has waned drastically over the past decade. In previous generations the then largest oil producing nations based in the Middle East could, to a large extent, collude and set both prices and global output levels to maximise profitability of those countries and their beneficiary companies (read Big Oil).
The competitive landscape has changed drastically in recent times, with the advent of shale gas production in much greater quantities than previously forecast from non-OPEC sources (largely from the US), along with the significant improvements in renewables technology to both harness and store renewable-generated energy, as government subsidies from around the globe are wound back.
To make life more challenging for OPEC, these new kids on the block have significantly increased outputs at ever more economic costs of production. This has led to significant volatility in oil prices characterised by a long term price decline. Further the influence of OPEC has declined to the extent that its influence on prices is now marginal.
So what does this all mean for investors faced with this complex and changing energy environment? Even for those investors not specifically conscious of ethical and environmental, social and governance (“ESG”) considerations in their portfolios, these changes should be a signal to give pause ahead of any decision to allocate capital to an energy sub-sector.
First, we must consider the impact of shale gas. The huge production increase in shale over the last decade has helped to hasten the decline of OPEC and traditional oil producers. The chart below paints the picture of shale’s incredible growth in production - the vast majority of net supply additions come from non-OPEC sources - the majority of this being shale. This growth has been coupled by a significant reduction in shale production costs as technologies have improved and methods have been refined.
The environmental impact of shale production has been heavily criticised by highly credible scientists and engineers given the process of extraction has long-lasting negative impacts on the surrounding environment. Air pollution and water contamination due to the toxic chemicals used in hydraulic fracturing are the greatest concerns within fracking sites, while the need for wastewater disposal and shrinking water supplies are also pressing issues directly related to the procedure (Source: Investopedia, https://www.investopedia.com/ask/answers/011915/what-are-effects-fracking-environment.asp, accessed 8 July 2019).
Further while costs of production have come down, OPEC nations still enjoy a cost advantage over volume shale producers meaning there will likely come a price point where shale becomes uneconomic at which point OPEC producers can scrape by. The United States Department of Energy estimates that the ex-situ processing of shale would be economic at sustained average world oil prices above US$54 per barrel and in-situ processing would be economic at prices above $35 per barrel, assuming a ROI of 15% (Source: Wikipedia, https://en.m.wikipedia.org/wiki/Oil_shale_economics, Accessed: 8 July 2019). With the current price of oil hovering just above the higher price, some shale producers are likely to be marginal.
It is worth noting the future improvements in shale production technologies and processes to cut costs will likely bring these down further. The problem remains that the long term trend in energy price has been downward, driven by increased supply. The chart below demonstrates the volatility and significant declines in oil since the highs of 2008 and more recently 2014.
Source: Wikipedia, https://en.m.wikipedia.org/wiki/Price_of_oil, accessed: 8 July 2019)
Renewables have followed a similar trajectory to shale relating to increased volumes and reducing costs of production albeit off a much higher starting cost base, as new technologies were essentially “invented”. Over a short period of time economies of scale and technical break-throughs have brought down the cost of renewable energy production at a rate faster than shale production, and faster than many thought possible.
A recent Forbes report (https://www.forbes.com/sites/jeffmcmahon/2019/07/01/new-solar--battery-price-crushes-fossil-fuels-buries-nuclear/?utm_source=FACEBOOK&utm_medium=social&utm_term=Valerie/#76616c657269) which investigated one of the globe’s deepest and most advanced markets for renewables - California - has shown significant price declines in renewables to the point that they are less expensive than their non-renewable alternatives. Solar and wind in particular have moved the game forward to the point that they are no longer a “good for the planet at the expense of my pocket” proposition. They now are starting to offer a viable alternative to traditional sources of energy.
Even the more conservative US state of Indiana has pledged that they would revert from coal and gas to renewables within a decade (Source: Forbes, https://www.forbes.com/sites/jeffmcmahon/2019/07/02/mike-pences-indiana-chooses-renewables-over-gas-as-it-retires-coal-early/?utm_source=FACEBOOK&utm_medium=social&utm_term=Valerie/#2cd37bc343b4, Accessed: 8 July 2019). This change has been driven wholly by the economics of solar and wind renewables.
For investors, particularly value investors, the state of the global energy industry at current offers a conundrum - the value opportunities in energy see non-renewables as “cheap” while renewables have, to this point, been in “start up phase” reliant on subsidies to offer an economic alternative. While non-renewables have been faced with price declines and large supply increases, renewables have seen growth in both supply and demand while very large subsidies have been wound back globally, and in many cases removed altogether.
The following chart depicts the increase in renewables energy production off a very small base yet it is already eating into the traditional sources:
There may be some opportunities to buy some “cheap” non-renewable assets, however these may prove a false-economy against non-finite renewables that continue to become less expensive to produce thanks to technical and process innovations. Unless the economics of oil, coal and gas can continue to push costs down to similar extents (doubtful given how far costs have already come down), the industry is facing an existential crisis over the course of the next generation.
On the flip side, investing in renewables can be fraught. Technologies are still emerging and company claims often do do not reflect reality or likely outcomes and as a consequence separating future industry winners from losers is challenging. Very few renewables companies have demonstrated a sustainable business model to this point.
Nevertheless, renewables will offer patient, diversified long term investors, opportunities to benefit from the increased production volume as the sector continues to cannibalise non-renewable sales. The fact that this will be helping the planet along the way may just be a fringe benefit for some, while for others it will be the main game with economic profit offering the cream.
Renewables offer significantly more upside as an investment, with the traditional caveat around company-specific risks and understanding their business model and customer profile, and the more nuanced one focused on any specific innovations they bring to the table and how they will help increase volumes and/or lower production costs.
So indeed the fossil fuels may not be losing the race at this point in the cycle, but the gap is closing fast and smart investors are ready to pounce.