Oil in retreat

Oil in retreat

Pandemic has accelerated decarbonized future


Last time (see my Sept. 1 article, "Legends of oil's fall"), I looked at oil’s decline as a fuel since the “peak oil” fears of the early 2000s, and the subsequent rise is shale oil extraction. The decline has been hastened by the development of more econmically efficient alternative energy sources. I drew a parallel with the 1979 novella Legends of the Fall, by Jim Harrison. The pandemic of 2020 might just have provided the catalyst for a significant transormation.

Covid-19: the accelerant

The slowdown in global economic activity triggered by Covid-19 lockdowns caused major distortions in the oil market in 2020. Falling demand and rapidly shrinking storage capacity caused an unprecedented dislocation in the futures market, with oil temporarily trading near negative US$40 per barrel. While order has since returned to the market, prices remain about the same as their pre-pandemic highs.

In recent years, falling oil prices have been a reliably troubling indicator for renewables and EVs; effectively decreasing their competitiveness for cost-sensitive consumers. However, it appears that 2020 bucked that trend. Remarkably, despite a sharp downturn in automobile sales this year, EV sales actually increased by approximately 6% to 2.3 million units. Investors have clearly taken notice, bidding Tesla’s stock up over 700% year-to-date; making its market capitalization greater than the next five biggest automakers combined.

On the political front, Joe Biden’s victory in the U.S. presidential election saw the nation (the world’s second largest producer of fossil fuel carbon dioxide emissions) quickly re-join the Paris Agreement. Covid-19 fiscal stimulus packages (particularly in Europe) have been structured to prioritize low-carbon investments. Approximately 30% of the European Union’s combined €1.07 trillion 2021-2027 budget and €750 billion recovery package has been earmarked for “green” projects.

Industry giant BP has revised its oil demand forecast, predicting that annual consumption will never surpass the level reached in 2019. Time will tell if this is too aggressive. Other estimates of “peak oil” demand range from 2028 (Rystad) to 2040 (Opec) to a “long plateau” from 2030 onwards (International Energy Agency). Regardless of exactly when peak oil is reached, with increasingly favourable alternative energy economics, widespread policy support and a continuing move away from internal combustion engines from both automakers and consumers, the trend towards a decarbonized future is irreversible.

Investment implications

In Jim Harrison’s novella, Legends of the Fall, Tristan Ludlow returned home from the war a broken man. Unable to resume his life on the homestead, he decided to travel the world, in hopes of reinventing himself and finding new meaning for his existence.

Today, it is the energy sector in need of reinvention. We are not suggesting the imminent demise of the sector, but that it has arrived at a pivotal turning point. Companies that have the foresight to divert their free cash flow from oil and gas capex to purchase and develop renewable energy assets should survive and even flourish. But inevitably, many companies will not act quickly enough.

Similarly, peaking demand is not an immediate death sentence for oil. From a cyclical perspective, oil prices will remain sensitive to global growth expectations. If falling capex sufficiently tightens supply conditions, one could even make a medium-term case for oil upside. But we would advise investors against getting too lathered up. Caution is still in order.

ESG investing is gaining momentum with institutional and retail investors alike, and carbon intensive investments have fallen out of favour. Covid-19 has caused behavioural shifts that will accelerate demand impairment (including reductions in business travel and commuting, which will endure longer than the pandemic).

Investor fears of stranded reserve assets will also overhang the market. Accordingly, we view oil as a potential tactical exposure to position for a cyclical upturn, but longer-term, we remain structurally underweight.

David Kletz, CFA, is Vice President & Portfolio Manager at Forstrong Global Asset Management. This article first appeared in Forstrong’s 2021 Super Trends Report. Used with permission. You can reach David by phone at Forstrong Global, toll-free 1-888-419-6715, or by email at dkletz@forstrong.com.

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