If you are an ESG investor, you should invest in big oil and gas companies. I know this sounds counterintuitive, but hear me out.
A decade ago, oil and gas companies were generally horrible investments, regardless of your stance on the environment. Corporate governance was abysmal, capital allocation was reckless, and little time was spent thinking about what would happen after oil. The environment was certainly not something companies thought about and sustainability was still technologically difficult – we didn’t have a cost-effective way to generate renewable electricity or power electric vehicles.
People who invested in energy expecting big returns as we entered the shale revolution have been riding a wild roller coaster and ultimately not making much money. Aggressive exploration and production has led to surpluses and overvalued transactions. Back then, avoiding energy companies was the right decision, whether you did it for environmental reasons or not.
Today’s energy companies are significantly different, both in terms of how renewables work and how they are designed.
Fossil Fuel Demand:
Today’s energy companies operate with a much more realistic set of expectations about the future. Like the general public, they understand that renewable energy is the future. Partly in response to environmental campaigns over the past decade, they are aware of and support the eventual transition of power. Around the world, energy company operators agree with this perspective. You may hear different timelines and projections for transitions to renewables, but ultimately most new power generation projects are renewables, whether you live in Texas, China, or California.
However, even as renewables become more viable, we also need to be realistic about how to frame the transition period. We still need fossil fuels. Some environmentalists may not like it, but it’s true – current oil and gas prices speak to the vulnerability of some of these supplies. We need natural gas to heat homes, keep lights on, and charge electric car batteries. Gasoline is still essential for most cars on the road, jet fuel is how our planes stay aloft, and plastics are still essential in the devices we use every day. We simply don’t have viable large-scale alternatives.
Since the need is real – who better to do the drilling and extraction than today’s big energy companies? We should support them, invest in them and help them thrive. Think about it, we are talking about essential goods with potentially high profit margins. At oil prices approaching $100 a barrel, someone is going to go out into the world and pump oil. It doesn’t matter how much you care about the environment – the reality is that someone is going to pump for that kind of price.
If you’re a conservationist, the real discussion should be who do you prefer to lead oil operations? An underfunded private operation with no government oversight or accountability, a group that cuts corners to try to squeeze whatever profit it can? Or do you prefer someone like Exxon or Chevron
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Big Oil has decades of experience in complex operational excellence. They are closely monitored by government regulatory agencies. They have significant balance sheets to pay for rehabilitation or clean-up in the rare event that they have an accident on the spot. These are big institutions that you can hold accountable and have come under harsh criticism from the general public and financial markets for their environmental stances over the past decade.
In short, if you have to pump oil, these are the kind of bands you want to do.
Additionally, let’s look at the positive externalities if the big US energy companies are the ones filling the fossil fuel supply gaps. They are based in the United States, so profits are taxed and distributed here. They create jobs here. And beyond that, because of the pressure ESG groups have put on big energy over the past few decades, much of the profits are now plowed back into the research and development of alternative energy supplies.
In particular, we would name energy companies as likely leaders in carbon sequestration efforts. Energy companies have operational expertise in drilling, injecting and monitoring various geological formations. They have significant human capital advantages and large equipment inventories, giving companies a natural advantage over other entrants to the space.
Likewise, energy companies that currently focus on transporting and storing fossil fuels are naturally suited to future technologies such as hydrogen. Expertise in refining, compressing and transporting complex substances is hard to come by. Mid-market refining and transportation companies are in the perfect position to leverage existing expertise and infrastructure, revamped for a renewable era.
Energy market dynamics:
Energy companies also look attractive from a more structural point of view. Oil production globally has struggled to keep up with demand as a number of different factors have impacted investment and production. The Russian invasion of Ukraine is the obvious disruption – Russia supplied a significant share of Europe’s natural gas and oil. But Russian aggression isn’t the only problem – if the war ended tomorrow and sanctions were lifted, the world would likely still face tight energy markets.
Three main factors explain this more structural problem.
First, Russia is not the only country whose supplies have been disrupted by violence or corruption. Several other major energy producers have also experienced political difficulties in recent years and have seen their production decline. Venezuela and Libya are two prime examples, and Nigeria is rapidly seeing its energy production plummet even as it steps up imports of refined products. Individually, a country struggling with production doesn’t have such an impact, but in recent years we’ve seen millions of barrels per day of production leave the market due to geopolitical tensions or mismanagement.
Second, and perhaps most importantly, we have seen widespread underinvestment in energy in recent years. This is partly due to policy realignment toward renewables, partly to more ESG-sensitive public markets, and partly to a decades-long shift in how energy companies deploy capital. However, the cumulative impact is significant; we haven’t seen a new refinery built in the United States in a very long time. Oil and gas transmission pipelines have faced significant construction hurdles, although they are significantly safer than transport by truck or rail. Exploration and reserve expansion also declined.
Third, the technology used to extract oil has changed. The shift from traditional drilling to shale has dramatically shortened the investment cycle. Shale well production is heavily weighted toward the first 12 to 24 months. In order to maintain the same oil production, you must constantly drill new wells and reinvest capital. While this is good for individual oil companies – they can each be more cautious about how they invest and react to markets and their own capital position – it does make the overall market supply more volatile as there are fewer constant or base charge barrels produced.
Cautions and investment:
Combine all of the factors above and it paints a pretty rosy picture for the energy sector as a whole. It is a strategically essential sector with an attractive structural dynamic of supply and demand.
However, it should be noted that the energy space is exceptionally volatile and can change rapidly. The world is likely approaching a recession if we’re not already there, and geopolitics can change quickly. A space’s structural support may not be enough to overcome the cyclicality of the sector. This means that if you’re considering investing in space, you’ll probably want to stick to the big companies – Chevron, Exxon and the other oil majors. They have the strongest balance sheets, can weather a downturn, and with a renewed focus on the environment, they have strong corporate governance and large research budgets.