The Energy Industry: The Transition Towards Cleaner Energy and Its Impact on Investors
by: Smith and Howard Wealth Management
The energy industry and some of the trends we are seeing in sustainable or renewable energy sources has been a topic of conversation with clients for a while, but the frequency of those discussions has definitely picked up over the last year or so. Oil trading at negative prices during the early part of the shutdown and some of the election debate around energy policy were probably a big reason for that. More recently, though, we also saw the complete breakdown of the electricity grid in Texas, which again spurred discussions and ultimately this conversation with Brad Swinsburg, Chief Investment Officer at Smith & Howard Wealth Management.
Q: What do we know about what happened in Texas?
A: The Texas situation is a really interesting one for me as it takes me back to my first job out of college. I started my career as a credit analyst in New York, focused on electric utilities and specifically power generation. One thing you quickly learn about the industry, is that Texas is essentially an island when it comes to power generation and transmission. What that logistically means is that the Texas power grid is not really connected to that of the surrounding states – at least not in a meaningful way – so in a sense they can’t import power generated elsewhere. That was one major issue. The other big issue was that their power supply wasn’t really “winterized”, meaning that it wasn’t built to withstand long periods of cold temperatures across a large portion of the state.
Q: Some headlines appeared to blame the Texas situation on the use of renewables. Can you touch on that?
A: There is plenty of blame to go around with regard to what happened in Texas, but the reality is that this wasn’t an issue of renewables or even fossil fuels. It was the isolation of the power grid and not building or upgrading it in a way that allowed it to withstand the cold spell. Renewables like wind and solar absolutely experienced outages, but so did fossil fuel power sources, not to mention the fact that even a nuclear plant was offline for a period. The source of the power wasn’t the issue. To put perhaps a finer point on it, insulated or winterized properly, solar and wind work fine in Antarctica. When it comes to who to blame, as usual the list is long – regulators didn’t require the winterization and companies opted not to spend the money to do it voluntarily.
Q: In the introduction to this conversation, we mentioned energy policy and the election. There was quite a stark contrast on this subject between the two parties and specifically the two presidential candidates. Could you touch on some of what we’re likely to see from the Biden administration on energy policy?
A: While I generally like to try and steer clear of political debates, I want to relay the two big points that one of our energy-focused managers conveyed on a recent update call. The two things they kept coming back to were 1) expect more bark than bite and 2) so far the new administration hasn’t done anything different than the industry expected or that will really be much of a disruption.
Q: So a lot of these new policies, like the ban on drilling on federal lands, are not disruptive?
A: Maybe disruptive isn’t the right word, but what was announced has not been a surprise to anyone in the industry, including new policies, like the ban on drilling on federal lands. There are two things to consider with the ban on federal lands – first is leasing and the second is permitting. The moratorium on leasing federal lands is probably not as big of a deal as the headlines make it sound. Most of the best acreage for drilling has already been leased and the ban is likely temporary. As for permits, everyone knew it was coming and producers built a three- to four-year backlog of permits, so it’s going to be years before they really see any production impact from that.
Q: Let’s switch gears for a bit and talk about climate change. The buzzword when it comes to climate change is carbon: carbon emissions, carbon capture, carbon sequestration and so on. Can you help people understand in layman’s terms what the issue is with carbon?
A: Well, I’ll give it a try. Carbon itself is a natural element and is literally everywhere – every cell in our body, the compounds in rocks and soil, the very chairs we’re sitting on. When scientists talk about carbon in relation to climate change, what they are really referring to is carbon dioxide or atmospheric carbon. There is a carbon cycle where carbon moves between the atmosphere and the ocean and land over millions of years. The reason carbon is such a buzzword is that humans have in a sense altered that cycle – our industrial processes and societal needs have resulted in more carbon dioxide being released into the atmosphere. This has created imbalances that manifest themselves in things like rising sea levels and changes in weather patterns. Trying to stick with the big picture then, the goals of most climate change efforts are to 1) reduce the amount of carbon emitted into the atmosphere or 2) reduce the amount already in the atmosphere via what is referred to as sequestration or capture.
Q: When it comes to climate change the whole fossil fuels versus renewables debate is a tricky topic to navigate with people. What do you say in those situations and how do you think people should approach it or think about it?
A: You are correct. It is a tricky topic. We live in an increasingly binary world that pushes us to pick sides or choose between two extremes. As is the case with a lot of things like that, the truth or reality often lies somewhere in the middle, and I think that is the case with energy.
Q: Can you expand on that? What do you mean by the truth lies somewhere in the middle?
A: It’s become increasingly clear that future sources of energy will include some mix of both fossil fuels and renewables. Regardless of what people may want or what we might aspire to, there are a host of practical and logistical reasons that fossil fuels aren’t going away and the use of renewables will continue to progress.
Let’s look at fossil fuels first. Coal, oil and natural gas today make up about 85% of our primary energy supply. Obviously, climate change concerns related to those fuel sources and our dependence on them have led to the development of and innovation around renewable sources like wind, solar and hydrogen. The argument for fossil fuels or against renewables has typically been one of cost. There is still some truth to that as renewable projects are typically less economical than fossil fuels, but the differential is now small and it continues to shrink. The improved economics of renewables has resulted in many energy companies shifting their business mix to increasingly and meaningfully including renewables.
Now the flip side of that is that you have a segment of the population that wants to do away with fossil fuels yesterday. I think most of those folks ultimately realize that isn’t actually feasible, but in a lot of those discussions there is still probably too much optimism on how fast a transition to renewables could realistically occur.
One of the big misperceptions is around energy consumption. Most people focus just on basic electricity generation, but that is only about a quarter of energy consumption – industrial and transportation make up large portions and are to this point more difficult to meet with renewable power sources. Let’s look at steel as an example. Steel production is the single largest industrial source of global CO2 emissions, but because it requires producing heat in excess of 1,000 degrees Celsius, the science isn’t there yet to do it through renewables.
That doesn’t mean the science can’t get there, and there are several efforts focused on using hydrogen that are promising. Arcelor Mittal, the largest steel producer in the world, announced plans to construct a plant that would aim to use hydrogen instead of coal. As exciting as that is, the output of the plant is expected to only be about 100,000 tonnes per year, which is about 0.01% of global steel production today. The other thing is that even once the technology has been proven, it will take decades to build out additional production facilities. Sweden, for example, has shovels in the ground on another hydrogen fueled demonstration plant and they aren’t expected to be at full capacity with that plant until 2045.
Q: You mentioned Arcelor Mittal. Let’s talk about some of the things we are seeing from big, public companies. It seems like there has been a noticeable shift.
A: I don’t think there is any question that there has been a shift. Now, I don’t want to be naïve and not recognize that some of what we hear or read is for PR purposes, but there is also real money being spent. In fact, 2021 is likely to be the first year in which more money is spent on developing renewable power than on oil and gas projects. That fact alone might be a bit surprising given the size of the oil & gas industry, but it might be even more surprising to realize that some of the biggest spenders on renewables is the oil and gas industry itself.
Q: That is interesting, but isn’t it rather counterintuitive or counterproductive?
A: In the short term, yes, but I think most now see the long-term opportunity and potential with renewables. Again, I don’t want to ignore the image aspect of this. Over the years, we all know they’ve had some very public and high profile missteps. I do think the bigger piece, at least today, goes back to what I covered earlier – the improving economics of renewables. It may not be quite on par with fossil fuels yet, but it’s close and these companies know that if they are going to be a player in the future, they need to get in now and develop some expertise.
Q: You’ve talked generally about the industry, but are there specific companies or projects to point to that “prove” the commitment or intent?
A: Absolutely. There has been a pretty steady drumbeat of announcements on that front, but I’ll tick down through a few recent ones:
Q: Let’s turn for a bit to investing. If investors are interested in participating in the growth and development of renewables, what are some things they need to consider?
A: That’s one of those questions without an easy or straightforward answer. One wouldn’t think, for example, that by investing in Exxon you’d be getting exposure to renewables. To be fair, Exxon is still primarily a fossil fuel-oriented company and so the exposure would be somewhat limited. That is really kind of the first decision an investor needs to make – do I want to invest in a pure play, renewables only type company or something more diversified? The pure play, renewables approach is exciting and could have an enormous upside, but it’s naturally going to come with a lot more risk. To add to that, a lot of those companies are still private, so the public at large can’t really invest in them yet.
There are a lot of options being created by Wall Street as we speak, which always makes me a bit nervous or cautious. Wall Street is great at creating buzz around a theme and then, no surprise, having the recently created product to meet the resulting demand.
This is a bit self-serving because we have an allocation to this space already, but one area that we might point folks to are some of the energy pipelines. The pipeline companies aren’t as well-known as the Exxons and Schlumbergers, and they are mostly focused on transporting oil and gas, but they are also getting heavily involved in renewables and clean energy. They are investing in wind and solar projects and exploring ways to use their already existing pipeline infrastructure to transport hydrogen and renewable natural gas. Unlike some perhaps more speculative, renewables-only investment options, these are real businesses with existing cash flows and earnings, but with the potential to capitalize on the growth in renewables.
Q: A little earlier, you mentioned companies like Schlumberger, Total, BP – all international companies. Can you tell us a little more about what we’re seeing globally?
A: Yes, every region and country is going to look a little different because we all have varying starting points, but the movement towards cleaner energy sources is global and is picking up speed. BloombergNEF, a clean energy research firm, estimated that more than $500 billion was spent in 2020 on what they call “energy transition investment.” Of that, Europe spent $166 billion, the U.S. $85 billion and, surprisingly, China was at about $135 billion.
Q: Since you mention China, let’s focus on Emerging Markets. I know the general sentiment or belief is often that we’re making progress in the developed world on reducing emissions, but the same progress or even effort isn’t being seen in emerging countries. Is that a fair assessment?
A: Yes and no. On the first part of that, yes, emissions in the U.S. are expected to have fallen last year, but we still have one of the highest emissions rates per capita in the world. So we need to continue to do better.
With regard to Emerging Markets, emissions there are still increasing generally, but I think it’s important to point out that a large part of that is because the developed world has simply shifted or outsourced a lot of its manufacturing or production in things like steel, cement and plastics – all high carbon emissions items – to those countries. Looking just at the emissions output by country may not be the best measure, especially since the global net result is all that matters when it comes to climate concerns.
Q: Since that shift in manufacturing is such a key component of the metrics, what does it look like if we strip that out? Where are the emerging markets on the spectrum of renewables adoption?
A: I always hesitate to paint all emerging markets with a broad brush, but I don’t think there is any real debate that in most cases, they trail the progress we see in the developed world. Unfortunately, that is also not something that can be changed quickly, but there are steps being taken in the right direction even as they continue to use fossil fuels. For example, Enterprise Products Partners, an energy pipeline company here in the U.S., estimates that 100 million homes in India have converted from burning wood and coal for heating and cooking purposes to propane and butane. Propane and butane may not be as clean as renewables, but they are far cleaner than wood or coal. Those sources are also safer in the short term as the World Health Organization estimates that in-home air pollution from things like burning wood and coal causes more than 4 million deaths a year. So again, positive steps even if there is a lot more work to be done.
Q: I’m curious – you said that the statistics on India were from a U.S. energy pipeline company. Why were they commenting on this?
A: One of the biggest business opportunities for pipelines and companies like Enterprise Products is in exporting things like propane, butane or what are more broadly referred to as natural gas liquids (NGLs). There is certainly still sizeable demand in the U.S. for those products, but since we are one of the lowest cost producers of NGLs, there is growing demand from places like India and developing economies in Asia. It’s another reason we like the pipelines from an investment standpoint.
Q: Any last thoughts on things for people to consider as they read more or hear more about the changing energy landscape in the months to come?
A: I guess what I’d hope people would take away from this conversation is that regardless of personal views, both fossil fuels and renewables will have a role to play in meeting future energy needs. Investors who want their dollars dedicated to one area or another should certainly be respected, but I think the more they dig into things, the more they’ll also realize how blurry some of the lines are. Here’s one last example – Tesla, one of the quintessential green companies, is talking about drilling for natural gas in Texas to help power its new Gigafactory. We need to try and keep an open mind on what being green means and be realistic about how quickly things are going to change. The train has clearly left the station on renewables being a viable energy solution, but it’s probably going to be a long and bumpy ride.
If you have any questions on the energy industry and some of the trends we are seeing in sustainable or renewable energy, please contact Brad Swinsburg.
Unless stated otherwise, any estimates or projections (including performance and risk) given in this presentation are intended to be forward-looking statements. Such estimates are subject to actual known and unknown risks, uncertainties, and other factors that could cause actual results to differ materially from those projected. The securities described within this presentation do not represent all of the securities purchased, sold or recommended for client accounts. The reader should not assume that an investment in such securities was or will be profitable. Past performance does not indicate future results.
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