Dinosaurs in a net zero future?
With the launch today of the government’s Net Zero Strategy: Build Back Greener, the Association of Investment Companies (AIC) has spoken to managers about their fossil fuel holdings. Ahead of COP26 next week, they discuss the investment case for oil and gas, the steps fossil fuel companies are taking to achieve net zero, engagement versus divestment and the current energy shortages and prices.
Why invest in fossil fuels?
Simon Gergel, Portfolio Manager of the Merchants Trust, said: “It is important to remember that the energy system remains a critical part of our economy, without which almost everything would cease to function. The world still relies on fossil fuels for over 80% of its energy. The demand for energy is very likely to continue to grow over time as emerging economies develop and industrialise. Although there is going to be a transition away from fossil fuels, the high capital intensity of the energy industry means this is going to take a very long time and require huge investments.
“Natural gas, which is considerably less carbon intensive than oil, is likely to remain a key component of the energy mix for decades, especially as coal use for power generation switches over to gas. There has been very little investment in the fossil fuel industry since the oil price crash in 2014 and the industry is now running up against supply constraints which is likely to support prices for the foreseeable future. The stronger prices of recent months are due in part to these supply side issues, although there are some shorter-term factors at play as well. In any case, a supply constrained environment is typically the best one in which to invest in energy companies. Finally, valuations across the sector remain very attractive even after the recent share price moves.”
Alasdair McKinnon, Manager of the Scottish Investment Trust, said: “The truth is that there are no easy answers and that the use of fossil fuels will remain a very important part of the energy mix for the foreseeable future. Oil and gas companies now recognise their need to aim for a net zero future and are among the largest investors in renewable energy. We believe that a policy of disinvestment will not hasten the move to net zero. We prefer to back companies that have strategies to reduce harmful emissions while importantly delivering strong cash flow to reward shareholders.”
Iain Pyle, Investment Manager of Shires Income, said: “Within Shires Income we hold positions in the UK-listed integrated oil companies, Shell and BP. In both cases we have a positive view on the investment case in the short term. The companies have been disciplined through a period of low commodity prices and are now generating material free cashflow as prices rise. This should support increasing dividends, buybacks and deleveraging and the shares appear well priced.”
Energy prices and shortages
Alasdair McKinnon, Manager of the Scottish Investment Trust, said: “Everyone would like to move as quickly as possible to the cleanest forms of energy. But as energy is critical to our civilisation, this transition should be balanced by the need for energy security and cost-effectiveness. The events of the past few weeks, with utilities going bust and empty filling stations, have demonstrated how worried most people get if energy suddenly becomes expensive or appears to be in short supply.”
Simon Gergel, Portfolio Manager of the Merchants Trust, said: “Our holdings are biased towards natural gas because we believe gas is a critical transition fuel in the decarbonisation process due to its lower CO2 footprint when compared to other fossil fuels. This is likely to underpin demand for a long time to come, whilst coal and, eventually, oil decline. Because of this our holdings have benefited from the recent upward moves in gas prices.”
Engagement vs. divestment
Iain Pyle, Investment Manager of Shires Income, said: “Our approach to investing in fossil fuel companies is one of engagement and discussion rather than divestment. Simply, we see this as a more effective way to encourage change and hopefully to create value for our shareholders at the same time. When we invest in oil and gas producers we have to assess the company on a number of levels. Firstly, is it a good investment for our shareholders? We are looking for companies with strong cash generation, the ability to pay sustainable dividends and the potential for capital growth, either through earnings growth or due to an attractive valuation today.
“Secondly, we need to be confident that the companies are committed to making their businesses fit for a future energy scenario where oil and gas is a declining part of the energy mix. There should be commitment to reducing carbon emissions and remaining disciplined on investing in hydrocarbons, but also a clear strategy for creating value from exposure to new energy sources. In engaging with companies as investors, we need to make sure to hold them to account on their commitments to the environment. Progress has certainly been made on setting medium-term targets and starting to decarbonise the businesses, but more likely needs to be done and we need to make sure that targets are aligned with the climate goals of society.”
Simon Gergel, Portfolio Manager of the Merchants Trust, said: “We are firm believers in engagement and we argue strongly against divestment. Indeed, we believe divestment will be counter-productive because it will simply force energy companies into making cosmetic disposal decisions to please the stock market but which do nothing to help the climate crisis. It is important that all stakeholders – investors, politicians, NGOs – understand that if big energy companies sell down their oil and gas assets, the buyers will mostly likely be private or state-owned oil companies. The assets will continue to produce oil and gas, but there will be much less oversight, making it harder to monitor and, ultimately, achieve the goals of decarbonisation. The listed energy companies only account for a relatively small portion of overall energy production and supply, but they have enormous knowledge and resources when it comes to harnessing new technologies and making them an economic reality. And this is what they are doing by using the cash flows from fossil fuel production to invest in new low carbon sources of energy.”
Fossil fuel’s steps to reach net zero
Simon Gergel, Portfolio Manager of the Merchants Trust, said: “In the past 12 months, both BP and Shell have set out plans to achieve net zero across their operations. Shell in particular has gone into a lot of detail on what they need to do, but also what needs to happen from other stakeholders such as their customers and host governments in order to achieve this. For their own operations, the actions include stopping new frontier exploration for oil, and investing in the low carbon economy including renewables, electric vehicle charging, hydrogen and sustainable aviation fuel. One thing that is clear is that there is no silver bullet to achieve net zero. Multiple new technologies will need to be developed, with a collaborative and open-minded approach by all parties when it comes to making these technologies a commercial reality.”
Iain Pyle, Investment Manager of Shires Income, said: “Longer term, BP and Shell have clear strategies to address the energy transition. As well as reducing hydrocarbon production, BP is building significant exposure to renewable power in wind and solar and has a large electric vehicle charging business, for example. Shell’s ability to trade clean energy globally differentiates it from other companies and can be an enabler of the transition to a greener economy. These businesses are early-stage and are not yet well understood by investors – that should change over time.
“Alongside the majors, we also hold positions in a number of smaller oil and gas producer and services companies where we see the correct approach to energy transition. Energean is a gas producer in the Eastern Mediterranean whose new projects will allow Israel to transition away from coal-fired power. The company is also developing carbon capture and storage in Greece. Wood Group has historically been focused on serving the oil industry as an engineer and consultant, but is increasingly focused on infrastructure and new sources of energy such as hydrogen and renewables. Overall, our view is that the sector should not be discounted by investors: these companies can be a powerful force for change and contributors to decarbonising the global economy over time. By investing and engaging with the sector leaders, we see an opportunity to encourage this change.”
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