Investors and consultants frequently ask for the Global Value team’s views on sustainable investing. While we do not offer strategies that focus in this area, we do pay close attention to issues of sustainability because they may be a key to a company’s resilience over the long term. Some investors see the energy sector as the antithesis of sustainability, but we see things differently. In this interview, Benj Bahr, energy-sector analyst on the Global Value team, explains why.
- Environmental concerns—air quality, water quality, climate change—are driving some investors away from the energy sector. Why do you still have oil and natural-gas companies in your portfolios?
One of the biggest reasons for owning these companies is the economic necessity of energy—and of oil and natural gas, in particular.
One of the biggest reasons for owning these companies is the economic necessity of energy—and of oil and natural gas, in particular. For many purposes, fossil fu-els are the lowest-cost resource, and coal, oil and natural gas still supply more than 80% of the world’s primary energy. Fossil fuels account for as large a proportion of energy production today as they did in the late 1990s, when hydropower and nuclear power made up more of the balance.1
Transportation probably gets the most attention, and many people believe that electric vehicles will soon replace those powered by internal combustion engines. However, even if this were to occur, it would affect roughly one-third of total global oil demand. The other two-thirds of demand stems from such things as plastics, fer-tilizers and fuels for commercial vehicles and airplanes. For airplanes—about 10% of all oil demand and growing—at the moment there is no substitute for the energy density of fossil fuels.2,3 To make most plastics, the options are currently limited to an oil derivative or a gas derivative. For a company making nitrogen and phosphate fertilizers to feed a growing population, natural gas is a key input. Oil and natural gas appear to be inextricable components of the economic system. They are necessary for the quality of life that the developed world enjoys today and that the rest of the world is actively seeking to achieve.
Further, we also choose to own energy stocks because of their role as a potential hedge in portfolios we manage. We like to own securities that provide exposure to scarce real assets, such as oil and natural-gas reserves and infrastructure. The top three exporters of oil globally—Saudi Arabia, Russia and Iraq—account for close to 40% of oil exports. Iran, Nigeria and Venezuela, which are also major exporters, represent another 10%.4 If something were to go wrong in one of these countries—a possibility that is not hard to imagine—a meaningful portion of global energy sup - ply could become unavailable. If this were to occur, energy stocks might be poised to provide ballast to our clients’ portfolios.
Lastly, as value investors, we tend to sense opportunities when we perceive broad-scale selling of a sector or industry. Often, but not always, it is good to be buying when others are selling indiscriminately. In recent years, efforts by some investors to divest from fossil fuel stocks have contributed to our belief that there may be attrac-tive opportunities in some energy stocks.
- Many countries have agreed to reduce their use of fossil fuels. How does this affect your thinking about the energy sector?
We think the transition to other energy sources will be slower than many investors seem to assume.
Q: Of course, the world’s dependence on oil and gas can change, and oil demand may stop growing. However, we think the transition to other energy sources will be slower than many investors seem to assume. The energy density of gasoline is still more than 30 times greater than the best lithium-ion battery being produced today.5 Owners of electric cars still need to plug them in, and fossil fuels are cur-rently powering most of the charging stations. Renewable sources of energy have become cheaper over time, but wind and solar power still require government subsidies to compete with fossil fuels on the basis of price.
We do not underestimate the potential environmental concerns that surround the energy industry. But a review of past energy transitions suggests that moving away from fossil fuels will take time. In the mid-18th century, despite technological improvements that allowed for more efficient coal mining, it still took more than 100 years before coal surpassed wood as the world’s largest source of energy. It took another 90 years before oil surpassed coal in terms of consumption. And even as new technologies emerged, demand for all sources of energy continued to grow: Global wood consumption doubled in the 19th century even as coal became the primary source of energy, and coal demand grew 15% over the course of the 20th century despite increased reliance on oil.6,7 Historically, energy transitions have lasted for decades, not years.
How do you think about sustainability in the context of the energy sector?
As in all sectors, we are long -term investors who care about whether assets are going to be viable years and decades down the road. With energy companies, we need to understand the role of technology, the role of disruption, and the role of the regulatory regime.
We look for energy companies where sustainability and strong governance appear to be ingrained in the decision-making process. We think that if a company is acknowl-edging the risks that are ahead it is more likely to adapt to changes within the indus-try. Likewise, if a company consistently seeks out best practices, we believe it is more likely to have the ability to survive and thrive over the long term. We are not seeking businesses where management superimposes ESG standards from the top down. In our view, that could actually cause a company to stray from its competitive advan-tages. We want to see companies that think about the environment because they’re looking out 10 or 20 years into the future, and they’re realizing what they must do to survive and grow their business. They have to care about sustainability because they want to be more competitive than their peers. Their research and development align them with all their stakeholders, including regulators and customers. For them, sustainability is not an end in itself, but a means to an end.
Further, in thinking about sustainability risks to energy companies, it’s important to keep in mind that not all fossil fuels are created equal. Although there are envi-ronmental issues with natural gas, it is much cleaner to burn than other fossil fuels. Most new power plants being built today are fueled by natural gas, either to replace legacy coal or nuclear plants, or to supplement renewable technologies. We expect the demand for natural gas to remain strong, and it is the most likely current substi-tute for other fossil fuels. Currently, natural gas accounts for a large portion of our energy exposure.
- What have energy companies in your portfolios done to address ESG and sustainability risks?
Many of the companies we own are heavily focused on efforts to address environ-mental risks. ExxonMobil is a good example of that. The company is spending about $5 billion a year on environmental issues, which includes everything from cleaning up sites where it has already been, to helping local economies where it is currently active, to making cleaner barrels today than it did yesterday. Exxon spends about a billion dollars a year on research into everything from more envi-ronmentally friendly resource extraction to the production of biofuels. It employs 2,300 PhDs. Few companies in the world—and not many governments—have as great a capacity to address environmental issues. Exxon is spending much of that money to bring down production costs and emissions. This is a systematic, long-term process. And while it is popularly known as an oil company, in reality it has built its presence in natural gas to the point where this now accounts for roughly half of Exxon’s production.
When making investments in any sector, including energy, we examine the incen-tives a company’s board has implemented to motivate management behavior. In ExxonMobil’s case, the board has created incentives that are aligned with the com-pany’s long-term orientation. Members of the management team are paid in stock on the basis of metrics like shareholder returns and returns on capital, with compensa-tion vesting over a 10-year period. This aligns them with regulators, customers and other stakeholders on a long-term basis.
- Have you invested in any renewable energy companies?
We invest with an eye on a company’s competitive positioning, cash flows and value creation. In the energy space, we have favored energy production and services companies that have shown an ability to create value and generate free cash flow over a full economic cycle. In our view, renewable opportunities in the public markets have not reached that point on a stand-alone basis. A lot of money is going into wind farms and solar arrays, and on a one-off or discrete-asset basis, investors can make money from that with the help of tax benefits or other subsidies for their power out-put. The technology for renewables is becoming compelling, and we do not dismiss it. But we want to invest in companies that can generate money across a cycle and pay us a dividend, conduct stock buybacks and create shareholder value over time. We don’t currently expect that renewables companies will be able to do those things in the near-term or medium-term. That said, we continue to pay close attention to renewables as we think about the long-term prospects for the energy sector.
- How much weight does sustainability carry in your investment process?
Today, we own shares in businesses that we believe by any metric— economic need, management alignment, company strategy—will be around for decades.
We view our value to society as protecting and growing capital for our clients in a thoughtful manner over decades. Throughout our investment process, we focus on sustainability and resilience, but valuation always figures into the equation. We want to invest in energy companies with assets and business models that are going to be around for decades—and a focus on sustainability is part of this equation. But we don’t rule out the possibility, under the right conditions, of investments with shorter asset life. Today, we own shares in businesses that we believe by any metric—economic need, management alignment, company strategy—will be around for decades. At the same time, in our view, the prices we are paying would be compatible with earnings that terminate in a much shorter period of time.
