The authors are CEO and director of the financial consulting company Complex. The factors in this column may invest in securities or instruments, including those mentioned therein. The foregoing does not constitute investment advice or marketing that takes into account the data and the special needs of each person.
Until the beginning of 2022, the trend line for reducing the use of fossil fuels (oil and gas) was sharp and clear. Investment strategies based on environmental, social and corporate governance (ESG) considerations have flourished, with an emphasis on the environmental field. For Oren, the traditional energy companies in the fields of oil and gas were required to present challenging targets for reducing pollutant emissions, while green energy companies were awarded high values.
However, the Russia-Ukraine war played out the cards, and illustrated that energy security is not self-evident, and can only rely on oil and gas in the foreseeable future. In particular, the challenges faced by Europe, despite huge investments in green energies, sharpened the understanding that they will not be able to provide sufficient energy production and storage capacity in the near future.
As a result, a renewed legitimacy was created for the use of fossil fuels, and in light of the withdrawal of Russian oil from the market at the same time, the prices of oil and gas soared, and with them the profits of the companies in the field.
Historic record profits for the energy companies
In 2022, the six largest energy companies in the West – the American ExxonMobil and Chevron, and the European Shell, British Petroleum (BP), Equinor and Total Energies – achieved the highest profits In the history of the sector: over 200 billion dollars together.
In response, the shares of some companies soared to historic record levels. However, this creates a built-in tension between copycat profits in the short term, and the understanding that these sources of profit, polluting oil and gas production, are not sustainable in the distant future. As a result, companies and their investors face complex dilemmas in formulating their business plans and evaluating the value of the various activities, in a way that in our opinion no sector has ever faced.
On the one hand, investors focused on short-term returns require investments in oil and gas production and drilling. This is over investment in large and prolonged projects of renewable energies, which yield much lower returns. For example, BP sets return targets of 15% to 20% for fossil fuel projects, compared to 6% to 8% in renewable energy.
Alternatively, those investors are required to maximize returns and cash flows in the short term, through increased dividends and share buybacks. On the other side are ESG-focused activist investors, who generate great pressure to reduce emissions and meet environmental goals, whose power is rapidly diminishing.
Environmental pressures have been exerted on European energy companies in recent years, against the background of the developed ESG field on the continent. That is why they invest much higher sums than their counterparts in the US in switching to renewable energies, which are less profitable as mentioned, and trade at profit multiples of about 6 on average, compared to about 11 in the American companies.
However, as a result of the significant changes in 2022, at the beginning of 2023 the European companies also changed direction. At the end of January, BP surprised the markets, when it announced that it would reduce oil and gas production in the coming decade by 25% instead of 40%. The move stems from its latest estimates, according to which the process of reducing the use of fossil fuels and the transition to clean energies will be longer than previous forecasts, with an expected demand of about 75 million barrels per day in 2050. This is a huge deviation from the 20 million barrels set for meeting the global goal of zero net greenhouse gas emissions.
According to BP, global emissions will only decrease by 30% by 2050, instead of the 95% required to meet the target. These are devastating predictions for the planet, which are a huge distance from meeting the goals of the Paris Agreement, of limiting global warming to 1.5 degrees by 2050.
As a result of the increased flows expected to BP, dividends have been increased by 10% and a share buyback of approximately $11.25 billion is planned. In response, the stock rose by 14%. At the same time, Shell also announced its intention to increase oil production targets.
Unlike the European companies, the American energy giants Exxon and Chevron resisted from the beginning the pressure of investors to switch to renewable energy, arguing that they have no competitive advantage in doing so. They are supported by a strong lobby from the oil-producing countries in the US, which oppose the integration of ESG considerations in investments.
Therefore, Exxon and Chevron have significantly cut capital investments in recent years, against the background of the lack of viability in developing oil fields in the long term, and have increased their profits and dividends. They face the environmental challenges by making a much smaller investment of developing carbon capture capabilities and biofuel production, which will allow the continued use of oil.
To illustrate, Exxon invests in reducing emissions only 8% of its total investments, while Chevron will spend only 2 billion dollars a year until 2028 on reduction projects, while 75 billion dollars will be allocated to buy back shares in 2023.
High risk of trend reversal again
In our estimation, the copy profits produced by the companies in the sector in 2022 are not representative. The sharp change of direction in the global energy market towards polluting energies is not environmentally sustainable, in our opinion, and is too biased towards energy security, despite the trauma that Europe has suffered. Therefore, there is a high risk of a trend reversal again, or a return to a more reasonable balance in setting targets for reducing emissions, in light of a renewed discussion of the damages of global warming.
Additional risks for companies in the field are the end of the Russia-Ukraine war, which will bring Russian oil back into play and increase the supply, a technological leap in energy production from clean sources or the increase of the excess taxation imposed on the sector in light of copycat profits.
The combination of the multiple risks with the high stock prices creates, in our opinion, an increased risk of sharp declines in the energy stocks, reversing the trend for 2022.
For those who like risk, in our opinion at the present time it is better to invest in the European energy companies, which trade at much lower multiples and are inclined to invest in green energies, which may yield fewer fruits, but with a higher level of security in the long term.
For activist investors and ESG activists, the withdrawal of energy companies from commitments to reduce emissions should provide much food for thought. The conclusion, in our opinion, is that a much more practical approach is required on their part to set realistic climate goals, which will allow for a more gradual reduction of emissions, alongside long-term energy security.