The world is in an energy crisis. High demand is meeting low supply, and businesses and households are facing exorbitant costs or are without energy all together.
At the same time, the world is looking with increasing urgency for solutions to avoid a climate disaster. Amongst the chaos is an opportunity for investors able to look through the noise. Despite the energy sector’s significant rally over the last 12 months, many oil and gas producers are still available at remarkably attractive valuations. Some may be deservedly cheap, but others appear to offer great value.
In a classic commodity cycle, a sharp rise in prices leads to new investments in capacity, which in turn brings forth new supply and ultimately pushes prices down. As prices fall, so too does investment in new capacity and thus supply, and the cycle repeats. We have seen this play out over many cycles in the energy space. However, this time things may be different.
In the last five years, U.S. majors (a proxy for energy producers globally) have invested less in energy infrastructure than in any other five-year period going back more than 70 years. Historically, these companies have spent about 10% of asset value on capex. Over the last five years that fell to 6%, and in 2021 it was just 4%.
Today’s supply crunch has been almost a decade in the making. It began with shareholder pressure for greater “capital discipline” following the 2014 commodity crash. This meant spending less on capex and returning more capital to shareholders via dividends and buybacks. Then came Covid-19. While the pandemic initially crushed energy prices as the global economy shut down and demand fell, it also meant even further downward pressure on investment. Most recently, Russia’s invasion of Ukraine has made the supply situation even more complicated.
Demand is now bouncing back—without China, by the way, which is forecasted to see a contraction in oil demand in 2022 for the first time this century—and years of underinvestment mean we have an unprecedented hole to fill. But here is the real challenge: for the first time in history, energy producers are not optimizing solely for cost and efficiency. They are also optimizing for carbon.
Fossil fuels have been an enormous windfall to humanity. Harnessing the energy they provide has allowed us to drive growth, productivity and ultimately improve quality of life. But it has not been without its costs, and we are running out of time to act. Optimizing energy production in a way that minimizes carbon emissions is therefore critical, but it will have a profound and, in our view, underestimated impact on both cost and efficiency. This dynamic will blunt the normal capital cycle, which may be longer and bumpier than the market expects.
Complicating matters further is the fact that global energy demand is forecasted by the U.S. Energy Information Administration (EIA) to rise by 50% from today’s levels by 2050—nearly all of which will come from the developing world. Even if the rich world could magically eliminate reliance on fossil fuels, there are billions of people still living in energy poverty (approximately one billion of whom consume less energy annually than a typical American fridge) and they must be lifted from it. But what mix of energy sources will they rely on?
On our current trajectory, the demand for both oil and gas is likely to grow for some time, even as their share of energy use declines. The last decade offers a sobering illustration of this dynamic. According to the EIA, fossil fuels accounted for 84% of global energy consumption in 2010 and 81% in 2020—a 3% drop over 10 years. But absolute volumes were up 6% because the aggregate demand for energy continues to grow.
So what does this all mean for investors? Absent a truly significant development in alternative energy technology, it seems likely we will see above average oil and gas prices for some time. High energy prices are a bad thing for most businesses and economies broadly, but we believe select opportunities among energy producers offer investors an excellent hedge against this risk.
Chesapeake Energy, Shell and Tourmaline are a few of our favourites. These companies are geared much more to gas than oil and we believe they can deliver attractive returns across a broad range of energy price scenarios. At spot energy prices, for every $100 invested, the companies generate about $20 in free cash flow — a measure of cash available to shareholders, much of which is being returned via dividends and buybacks.
Tourmaline is Canada’s largest natural gas producer with long-life assets in Western Canada. It sits at the bottom of industry cost curves thanks to operational excellence, scale and a cost-conscious culture. The company is led by CEO, Michael Rose, and CFO, Brian Robinson, who have successfully co-founded and sold two oil and gas companies. Tourmaline invested early in technology to reduce methane and carbon emissions and has the lowest net emissions among senior producers in Canada. As contrarians, it is odd to be excited about a stock that has tripled since the start of 2021, but with a free cash flow yield this attractive, it still feels like we’re going against the crowd.
Of course, the future of the energy sector is highly uncertain and each of these companies faces risks. In the short term, regulations could change, windfall taxes could be imposed, or we could enter a sharp global recession. In the long term, the world could transition away from fossil fuels far more quickly than expected. But rather than try to predict the future with any degree of precision, we think it is more useful to focus on valuations and the amount of capital companies are returning to shareholders. After all, as the cash piles up with each dividend or buyback, the need for investors to be right about the future only becomes less and less important.
Chris Horwood, MBA, CFA is an investment counsellor at Orbis Investments