Musings From The Oil Patch,September 8, 2020

• The Myth That Electric Vehicles Will End The Oil Business
• Oil Market Recovery Is Slowing; Should We Worry?
• ExxonMobil: End Of An Era Or End Of A Business?
• ESG Movement: Healthy And Accurate, Or A Scam?

Musings From the Oil Patch
September 8, 2020

Allen Brooks
Managing Director

Note: Musings from the Oil Patch reflects an eclectic collection of stories and analyses dealing with issues and developments within the energy industry that I feel have potentially significant implications for executives operating oilfield service companies.  The newsletter currently anticipates a semi-monthly publishing schedule, but periodically the event and news flow may dictate a more frequent schedule. As always, I welcome your comments and observations.   Allen Brooks

The stock of Tesla Inc., the face of the electric vehicle (EV) industry, has soared this year as its financial performance improved.  In fact, the company surprised Wall Street with a profit and outstanding vehicle deliveries in its second quarter results ending June 30, 2020, on July 22.  The company surprised analysts by delivering 90,650 vehicles worldwide.  This surpassed a set of analyst estimates compiled by Bloomberg projecting the company would only deliver 83,000 vehicles.  This delivery performance came despite the Covid-19 pandemic that caused many nations to shut down their economies, including Tesla manufacturing plants.  While deliveries were better than forecasted, deliveries were only 4.8% below those of the same quarter last year despite the slump in global auto sales.  Vehicle production in the quarter was 82,272, however, the company did not say how many vehicles were made at its new Shanghai plant versus its US factory in California. 

Exhibit 1.  Tesla’s Profit Performance Remains Marginal

Source:  Vox

The second quarter profit of $104 million extended the company’s run of profitable quarters to four consecutive quarters, despite revenue declining to $6 billion from $6.35 billion in the comparable quarter of 2019.  Once again, Tesla wasn’t profitable based on its sales.  It achieved profitability through selling $428 million worth of regulatory credits in the quarter, an increase over the $354 million of credits it sold during 1Q20, which was a record for the company.  Despite how Tesla achieved its profitability, the bottom-line profit led shareholders to drive the share price up nearly 9% in premarket trading the morning after the earnings release, after it had risen 3.7% prior to the earnings release.  The premarket share price was $1,219.02. 

Exhibit 2.  Tesla Share Price Performance YTD

Source:  Finance.Yahoo.com

Following the earnings report, the shares traded up, further driven by news of a new Tesla Gigafactory to be built in Austin, Texas, as well as tantalizing tidbits about battery technology breakthroughs.  What really sent the stock soaring was the early August announcement of Tesla splitting its shares 5-for-1.  The nearly doubling in share price since the earnings announcement only continued the incredible share price performance this year.  Until the middle of last week, Tesla shares are up 429%, as of the pre-market open on August 31.  During the final days of last week, the share price fell roughly 17%. 

The company’s amazing stock performance reflects the overall market’s fascination with technology stocks, which now includes Tesla.  This is quite surprising for an auto manufacturer, and one who only delivered 367,000 vehicles last year when the entire global industry sold approximately 95 million vehicles.  Tesla’s market value stands at approximately $400 billion, more than the cumulative market values of the top five auto manufacturers, who delivered 45 million vehicles in 2019.  The key to this extraordinary valuation is the perception of the future for the EV industry, especially as geopolitical trends are driving western economies toward zero-carbon emissions. 

Electrifying the economy is the proposed solution for limiting carbon emissions and their impact on the future climate.  According to data from the International Energy Agency (IEA), carbon emissions from the transportation sector in 2017 totaled 8,040 million metric tons of CO2, or 24.5% of total emissions that year.  Two sectors – air travel and maritime transportation – have few alternatives to hydrocarbon fuels, although cleaner fuel options are available.  The maritime industry introduced a global rule this year requiring all ships to use low-sulfur fuel oil, or as an alternative, employ air scrubbers to remove the sulfur from the exhaust from burning conventional bunker oil.  The air transport sector is testing biofuel alternatives to jet fuel, but the technological options to replace conventional fuels on a wide scale are almost nonexistent. 

Switching cars and trucks off of fossil fuels and onto electricity is perceived as the correct and highly desirable strategy to deal with climate change and protect future societies.  Those goals underlie the push for EVs, not just for cars, but for trucks and buses, too.  We are told to not worry about the inherent high cost of EVs, as the batteries that power them are expensive.  Batteries also impose distance limitations on EVs, something EV manufacturers are working on solving.  Most solutions for extending the distance an EV can travel have come from reducing the vehicle weight, slightly improving the battery’s efficiency, but largely by adding larger batteries.  A big problem is that the materials needed for batteries are limited at the moment.  In addition, they are associated with poor environmental processes in their mining and manufacture, and they often employ child labor in mining operations. 

Many studies have shown that the greenhouse emissions released in the manufacture of EVs mean they must be driven for 5-7 years to offset their legacy emissions with carbon-free driving.  Only after that driving period does the EV’s carbon-free driving contribute to a reduction in carbon emissions compared to those emitted in driving an internal combustion engine (ICE) car.  The lack of an extensive public charging network has been cited by many prospective EV buyers as a reason to not purchase them.  For some buyers, their living arrangements also limit charging options.  People residing in urban areas and in apartments lack access to personal charging stations, such as those that people in standalone homes are able to install.  Thus, while EVs could be very helpful in reducing emissions in cities, charging them becomes a significant impediment. 

EVs also are known for being expensive.  This has resulted in most of them being sold to particular categories of customers – high-income, environmentally motivated, and first-movers.  The high cost of EVs has been somewhat offset by subsidies from both the federal government, as well as certain state and local governments.  Even after the tax credits (assuming they can be fully utilized against a buyer’s income tax liabilities), EVs are more expensive than comparable ICE cars.  According to a new study about EVs in Europe by the Financial Times, utilizing data from consultant Oliver Wyman, they found that while EVs costs will fall by more than 20% by 2030, to €16,000 ($21,143), they will still remain 9% more expensive than ICE cars.  This gap will exist despite the cost of EV batteries dropping nearly in half over the next few years.  According to the Financial Times, this projection is bad news for the profit margins of European car companies. 

Exhibit 3.  EVs Will Still Be Expensive After Cost Cuts

Source:  Financial Times

Interestingly, the study showed that the cost of ICE cars will increase, but that increase is largely due to customer demand for luxurious interiors and more sustainably-sourced materials.  What is driving down the cost of EVs is advances in battery technology and production.  Although not noted, it is not impossible for a scenario in which the forces driving up ICE car costs begin to impact EV’s, too. 

The study found that the cost of a 50-kilowatt-hour EV battery will fall from the current average of €8,000 ($10,574) to approximately €4,300 ($5,684) by 2030, due to increased scale and the completion of several new battery Gigafactories in Europe and Asia.  Potential breakthroughs in battery development, such as the rise of solid-state technology as a replacement for lithium-ion, could bring down costs even further.  The timing of such an improvement, or if it can actually occur, is uncertain. 

One of the assumptions behind the forecasts for EV growth is that battery technology will lower the cost of EVs versus ICE cars.  However, the primary driver of the forecasts is the government mandates seeking to ban ICE vehicles from cities and highways in various countries.  Those mandates, along with tax subsidies, will push consumers to buy EVs, the only functional transportation option available.  What is often missed in these forecasts is that they are projecting the growth of ‘electrified’ vehicles, which means both battery-only EVs (BEV), as well as plug-in hybrid EVs (PHEV).  In some forecasts we have examined, the number of PHEVs is a significant component, and greater than the number of BEVs, which is certainly counter to the popular notion about the future of EVs.  PHEVs have gasoline-powered engines, as well as battery-powered motors.  This is something not acknowledged by those EV proponents who are predicting the end of the age of oil.  Is that out of ignorance or to mislead? 

The 2020 forecast by Bloomberg New Energy Finance (NEF) calls for the share of new car sales represented by EVs to climb from 2.7% in 2020 to 10% in 2025, 28% in 2030, and 58% in 2040.  That is a significant growth in EV penetration of global auto sales.  NEF suggests the number of EVs in the global fleet will rise from 8.5 million vehicles to 116 million in 2030, again a significant achievement.  They see the EV fleet growing to just under 500 million vehicles by 2040, suggesting a dramatic acceleration in new EV sales during the decade of the 2030s.  Interestingly, the IEA, another major promoter of EVs, sees that fleet at 245 million vehicles in 2030, considerably more than NEF. 

NEF sees the global vehicle fleet, which it estimates is currently at 1.2 billion units, remaining essentially flat, with a small uptick in 2022, before resuming its historical growth trajectory in 2023.  Based on its estimate for fleet growth, NEF projects a fleet of 1.4 billion vehicles in 2030, growing to 1.6 billion in 2040.  The key variable not provided in its forecast is the sales rate.  When we look at the history of vehicle sales globally, the past few years have experienced roughly 95 million units sold per year.  Since we know these were good years for automobile sales, we have assumed that represents peak capacity, based on operating plant capacity.  The industry has been working to reduce surplus manufacturing capacity by closing plants, besides shifting some manufacturing capacity to lower-cost countries.  In our modeling of the future EV market, we used 85 million units sold in 2020, but then increasing to 95 million a year and continuing at that rate for the entire forecast period.  Some forecasts are projecting sales eventually ramping up to 100 million a year.  We know that the manufacturing process for EVs involves fewer parts, thus the time necessary to build them is less than for an ICE, which effectively boosts plant capacity, but we are unable to estimate if or when any manufacturing capacity might be added. 

In Exhibit 4 (next page), we show the result of our forecast, which ties to the NEF data points in 2030 and 2040.  We also have put in the IEA 2030 forecast estimate, which clearly exceeds our forecast, and exceeds the NEF forecast.  The NEF estimate of nearly 500 million EVs in the global fleet falls slightly short of our 2040 forecast value of 565 million units.  Our forecast reaches 500 million EVs in 2039, as well as our forecast reaching 116 million EVs in 2029, suggesting that our growth rate assumptions are pretty comparable to those assumed by NEF. 

Exhibit 4.  Various Outlooks For EV Fleet Growth

Source:  OICA, inside-EV.com, NEF, IEA, PPHB

The forecast shows an accelerating growth in the EV fleet beginning in 2025.  This forecast certainly suggests the oil industry should be worried about its future.  The assumption has to be that with the number of EVs increasing as rapidly as forecast, the future for gasoline and diesel demand must be peaking and starting to decline.  According to NEF, EVs are already displacing one million barrels per day (mmb/d) of gasoline demand, and by 2040 it will be 17.6 mmb/d.  For reference, gasoline consumption for 190 major countries in 2017 was 26.3 mmb/d.  However, the future for the oil industry isn’t as bleak as suggested by the rapid growth projected for EVs.  When we look at the EV forecast compared to the projected growth of the entire global vehicle fleet, we see a stark reminder that oil will be needed for decades. 

Exhibit 5.  Composition Of Global Vehicle Fleet

Source:  OICA, inside-Ev.com, PPHB

As can be seen, EVs, including BEVs and PHEVs, will represent only a small portion of the global vehicle fleet.  Even if we model EV’s share of new car sales going from 58% in 2040 to 100% by 2049, the EV fleet still falls about 300 million vehicles short of saturating the projected 1.6 billion vehicle fleet of 2040.  Is it possible that EV sales as a percentage of total vehicle sales could nearly double almost overnight?  Maybe it could happen if autonomous vehicles are a success and a significant ride-hailing business evolves that causes suburban families to rapidly shed their second and third vehicles, at the same time the urban population abandons car ownership entirely.  In effect, the total global vehicle fleet would shrink rather than grow.  Is that realistic or possible? 

NEF is one of the most aggressive promoters of EVs and clean energy.  We think their aggressive position is influenced by perceptions that the United States, Europe and China will embrace EVs in the same way their citizens embraced cell phones.  The problem is that people do not purchase vehicles with the same short-term thinking when buying a cell phone.  Additionally, the United States, Europe and China have widely different reasons for welcoming the EV movement.  Furthermore, although those markets have large populations, they are barely growing, or are even in decline, while rapidly ageing.  The fast-growing populations are in Asia and Africa where people cannot afford expensive EVs, let alone have access to charging networks, which will likely be fueled with power produced from coal-fired power plants. 

When we modeled the potential growth of EVs, the challenges of securing the supplies of rare earth minerals needed for batteries becomes obvious.  There is little doubt that the environmental and social issues associated with producing these materials have yet to be fully assessed, meaning we have no idea what the economic and environmental costs might be, let alone the human cost.  Even if our model’s projections are off somewhat, the reality of our forecast shows that oil will be needed for several decades, and possibly much longer.  That doesn’t mean that oil’s use will grow as it has in the past.  In fact, it may not grow at all.  For the industry, the challenge will be to replace the lost production due to the normal reservoir decline rates.  That alone will keep the industry busy. 

Based on our modeling of the EV market, its growth will need to ramp up much faster and much sooner than projected to meet the carbon-free goals.  Despite government anti-fossil fuel mandates, there are many questions about the pace at which the global EV industry can grow.  This still ignores the issue of how many EVs will be PHEVs versus BEVs.  That too will impact fuel demand.  This outlook for the oil industry is quite different from the narrative EV promoters present.  Time will tell which outlook proves more accurate. 

Last week, The Wall Street Journal carried an article titled, “Fuel Rebound Loses Steam, Setting New Risks to Economy.”  Another article in that same edition carried the title “Factories Ramp Up, but Layoffs Raise Concern.”  The two articles are related, especially if one views economic activity closely tied to manufacturing, which drives energy use.  The writer of the fuel article was describing the trend of gasoline sales since their collapse in March and the sharp rebound when state economies began reopening in April, after being shut down to fight the spread of the coronavirus.  The economic re-openings have been spotty, marked by the emergence of virus hotspots, often forcing local and state governments to stop further loosening of restrictions, and in some cases, renewing lockdowns. 

Exhibit 6.  Gasoline Demand Within 10% of Pre-Covid-19

Source:  EIA, PPHB

As Exhibit 6 shows, gasoline supplied dropped 48% during the second half of March, but then rebounded 46% the following month.  While the gasoline supplied continued growing to satisfy increased driving, analysts are concerned demand growth has essentially flat-lined since early June.  There was a jump in supply during the week of August 21, but some of that gain was erased the following week.  Volatility notwithstanding, what is significant is that the last week of August was only 10% below the mid-March volumes of gasoline supplied, at the start of widespread state economies entering lockdown or semi-lockdown. 

U.S. gasoline consumption is important for the global oil industry, and for the health of the recovery.  We also need to be concerned about oil’s use worldwide.  The Energy Information Administration (EIA) published a chart showing jet fuel consumption by commercial passenger jets in important countries and regions.  The chart plots the seven-day moving average of the ratio of current jet fuel consumption versus 2019’s volume.  U.S. consumption at mid-August was 42% of 2019’s use, up from a 20% low of late April.  China, who experienced Covid-19 earlier and also began recovering sooner, saw its 20% low reached in late February and is now over 60%.  In contrast to other countries and regions, China experienced a recovery bounce in early March, before then declining until early April.  That recovery pattern was directly related to how China reopened its economy, which did experience some local retreats before resuming its opening. 

Exhibit 7.  How Air Transport Is Recovering

Source:  EIA

To see where the world may be in its return to more normal economic activity, although we do not know what that means, we turn to Apple Mobility data.  Unfortunately, China data was not available.  We have selected a representative country in each region to see activity in relation to the virus.  Not every country was impacted by the virus at the same time, which is evident in looking at the graph.  And, some countries are experiencing a rebound in virus cases, suggesting that fighting a second wave may require resorting to the drastic lockdown strategies used earlier. 

Exhibit 8.  Global Recovery Shows Troubling Growth

Source:  Apple Mobility, PPHB

What we see in the chart is how Germany and the U.S. seem to have tracked together when each country began reopening in mid-March.  The tightness in reopening between the two countries seemed to end in mid-June when U.S. activity appeared to flatten, while Germany’s continued upward.  Germany peaked in late July and then began declining, coming back into line with that of the U.S. 

Looking at the other countries, it is interesting to see how Egypt’s recovery has steadily grown once it turned up in mid-May, but its activity has become more volatile since early July.  On the other hand, India’s recovery has been steady since it bottomed in late-March, but the pace of the recovery has lagged that of other countries.  This pattern is similar to the recovery experienced by South Africa.  Both Brazil and Indonesia have experienced greater volatility as they recovered.  We are not quite sure what to make of that greater volatility, but in general terms, the two countries are now showing a flattening in their activity.  Overall, the picture of mobility data shows a noticeable flattening in activity globally, which is not a positive for a recovering oil market. 

An interesting perspective on the oil market is contained in the KAPSARC Oil Market Outlook for 3Q2020, published in August.  KAPSARC is the King Abdullah Petroleum Studies and Research Center in Saudi Arabia.  Their forecast takes a much more nuanced approach by factoring in risk factors.  As they assess everything, their oil price projections are based off of the oil futures curve.  What they show, however, is confidence ranges around that curve in their oil prices projections.  As shown in Exhibit 9, at 95% confidence capturing possible price projections, the May 2023 price range is between $17 and $150 a barrel.  Given that wide of a range, we are inclined to throw up our hands and say: This doesn’t help. 

Exhibit 9.  How Oil Prices Might Unfold

Source:  KAPSARC

However, as the confidence range narrows to 68% and then 50%, the projected price ranges narrow substantially, to $37 to $70 at the lowest.  While we may feel more comfortable with projected prices closer to the futures curve, the 95% confidence range should force you to think about how those prices could occur.  That is the value of this study.  It should make people preparing long-term business strategies think about the risk of their projections being wildly wrong. 

As one would expect, researchers at KAPSARC focus a lot on the global energy business and the economy of Saudi Arabia.  In that regard, researchers have produced a white paper entitled “Cooperate or Compete? Insights from Simulating a Global Oil Market with No Residual Supplier.”  This paper, which requires extensive study, attempts to assess what would happen to the oil market – supply, demand, prices, and investment – if OPEC, led by Saudi Arabia, abandons its long-term role as the market-balancing supplier.  What would happen to the oil market, and Saudi Arabia’s economy and government finances, if we had a totally free market? 

We have experienced free markets briefly in 1985-86, 2014-15, and 2020.  This last period also had the impact of the Covid-19 virus impact on economic activity.  Each of those periods was marked by sharp price moves and increased price volatility.  We won’t dig into the study other than to provide the highlights the authors included.  They offer some interesting perspectives on how the oil market might unfold, and what it means for Saudi Arabia’s, as well as OPEC’s, strategy going forward. 

• We investigate a transition to a competitive world oil market in which OPEC — led by Saudi Arabia — stops acting as the primary residual supplier within the world oil market starting in 2020. Our modeling results include the following highlights.

• In 2020, as OPEC ramps up production, Brent prices fall US$11.5/b below the World Energy Outlook (WEO) stated policies scenario of the International Energy Agency (IEA 2019).

• From 2020 to 2030, prices recover as a result of demand response combined with a need for sustained investment in new long-term conventional production.

• Only when capital approved for new conventional projects matches historic highs (present value of about US$125 billion per year) do prices remain below the WEO stated policies scenario through 2030.
• Crude prices recover faster and exhibit significantly higher variability when investment in shale oil production slows and output peaks at 12 million barrels per day (MMb/d) versus 16 MMb/d in 2025.

• A decline in short-term tight oil projects limits its role in balancing the market as a source of marginal production, compared to new conventional projects with longer lead times.

• Saudi Arabia benefits financially by continuing to act as the primary residual supplier only with strong cooperation from other producers in OPEC and the larger OPEC+ group.

We find the last highlight very interesting, especially in the context of the recent United Arab Emirates agreement with Israel.  We note that Saudi Arabia has just opened its air space to Israeli planes for the first time ever.  The geopolitics of the Middle East are rapidly changing after centuries of antagonism.  We believe the rise of U.S. oil production due to the shale revolution contributed to this geopolitical shift.  What other changes did the shale revolution drive, and how might they be impacted if U.S. shale oil production never returns to its prior levels, let alone its growth trajectory?  You need to be thinking about this as you assess the long-term future for oil. 

August 31 was a noteworthy date for the global oil and gas industry.  It was the day the stock of ExxonMobil Corporation was removed from the Dow Jones Industrial Index (DJIA) and replaced by the stock of Salesforce, Inc., a cloud-based enterprise software provider.  The reason for the switch is related to the 4-for-1 stock split by Apple Inc. on August 28th, and the mechanical composition of the index.  The DJIA is a price-weighted index, therefore, the drop in Apple’s share price from its August 27th price of $500.04 to $125.01 reduced the index’s technology sector weighting.  According to Howard Silverblatt, senior index analyst at S&P Dow Jones Indices, “Basically Apple — by itself — took the technology [weighting] within the Dow down from 27.6% to 20.3%.  It’s a significant decline,” he told CNBC.  “By adding Salesforce, you can come back to 23.1% of the Dow being in technology.”  The rationale for this switch is a telling omen for the energy industry. 

The ExxonMobil stock swap was only one of three made to better reconfigure the venerable DJIA.  It is a statement that the index needed to be changed to more closely reflect the relevance of various business sectors.  Created in May 1896 by Charles Dow and his business associate Edward Jones, the DJIA was composed of 12 stocks representing mainly industrial companies associated with gas, sugar, tobacco, railroads and oil.  Two years earlier, Mr. Dow developed his first stock index, the Dow Jones Transportation Average, which is acknowledged to be the best representation of the U.S. transportation sector. 

Exhibit 10.  DJIA Changes Since 2015 And Energy

Source:  PPHB

In Exhibit 10, we have listed the 30 stocks that compose the DJIA.  We have highlighted those stocks added to the index since 2015.  Chevron, which was added to the index in 2008, is now the only energy stock. 

The DJIA was expanded in 1916 from 12 stocks to 20, and the number of stocks increased to 30 in 1928, the year that Standard Oil of New Jersey, one of the three oil companies that were the founding components of the Standard Oil Trust, organized in 1882, was added.  The Standard Oil Trust included Standard Oil of New Jersey (Jersey Standard) and Standard Oil of New York (Socony), along with the foundational business, Standard Oil of Ohio, that had been formed by John D. Rockefeller and several associates in 1870.  That company had been created by combining the facilities of the various participants to create the largest refining enterprise in the world for making kerosene.  The name Standard was selected to signify the high, uniform quality of the product. 

In 1911, in a landmark decision, the Supreme Court declared that the Standard Oil Trust needed to be broken up on antitrust grounds.  The Trust was broken into 34 unrelated companies, including Jersey Standard, Socony and Vacuum Oil, a company purchased by the Trust earlier.  That year also marked the first time that Jersey Standard’s kerosene sales were surpassed by gasoline, a by-product previously discarded as a nuisance.  That development is one of many cases throughout the history of the oil and gas business when a nuisance eventually transformed itself into a significant contributor to the industry’s future growth. 

The history of Standard Oil of New Jersey shows the role the company, and the oil business, played in the growth of the American economy and improving living standards.  The 1919 purchase of 50% of Humble Oil & Refining Company of Texas changed the future of oil exploration.  Humble’s chief geologist, Wallace Pratt, was revolutionizing oil exploration with his use of micropaleontology, the study of microscopic fossils contained in cuttings and core samples from drilling, as an aid in finding oil resources. 

In 1927, Humble geophysicists, capitalizing on micropaleontology, used a refraction seismograph to discover a large oil field in Sugar Land, Texas.  One of the most significant exploration breakthroughs was the 1963 development of 3-D seismic technology that revolutionized how geoscientists could model the subsurface to find hydrocarbon resources that were not obvious from seeps or surface observations.  Another significant E&P breakthrough was perfecting the drilling of long lateral horizontal wells.  In 2007, Neftgas, an ExxonMobil subsidiary based in Russia, drilled the Z-11 well in the Sakhalin field, which was the longest measured extended reach well in the world.  The well measured 37,016 feet, a seven-mile distance.  Extended reach drilling helped open up the exploitation of shale resources in the United States and elsewhere. 

On the product side of petroleum, Jersey Standard was the first company to produce isopropyl alcohol (rubbing alcohol).  It is utilized in the manufacture of a wide variety of industrial and household chemicals and is a common ingredient in chemicals such as antiseptics, disinfectants, and detergents.  Seventeen years later, the company produced artificial rubber (butyl).  This proved very significant as a substitute for natural rubber that was dependent on imports from Southeast Asia and was limited during World War II.  Today, the majority of the global supply of butyl rubber is produced by two companies, with ExxonMobil being one of them.  Finally, in 2001, the company developed the SCANfining process, involving a new catalyst, that removed more than 95% of the sulfur from gasoline while minimizing octane loss.  This was a major contributor to cleaner air. 

As the popular warning in the financial industry goes: past performance is not a guarantee of future performance.  Thus, everything ExxonMobil has contributed to the success of the global oil and gas industry and to vastly improved living standards means nothing in today’s stock market.  People forget how significant was the oil and gas industry’s contribution to the economic recovery from the 2008-2009 financial crisis and recession.  A study by economists at the Dallas Federal Reserve Bank showed that oil and gas was a meaningful force in that recovery.  A summary paper stated:

“How did the shale boom affect the rest of the economy?  Our model indicates that cheaper fuel prices allowed households to consume about 3.6 percent more fuel. Households also increased their consumption of other goods because the decline in fuel prices increased their disposable income, leading to a 0.7 percent increase in overall consumption.

“The decline in fuel prices increased firm fuel use in the energy sector and in non-oil sectors, according to the model.  Our model shows that lower fuel prices led to higher output in non-oil sectors and higher U.S. aggregate investment.  Altogether, these effects led to a GDP increase of 1 percent in 2015 relative to 2010.

“Given that the actual increase in U.S. GDP was 10 percent over the period, the shale boom accounted for one-tenth of the overall increase.  Although the oil sector makes up less than 1.5 percent of the economy, our results suggest that the shale boom generated significant positive spillovers.”

The significance of the shale boom was summarized by the authors of the working paper.  They highlighted how shale production has reduced the nation’s oil imports and export. 

“In 2006, before the shale boom, the U.S imported about twice the oil it produced. That share has declined to two-thirds of domestic production. As a result, the U.S. petroleum trade balance narrowed from negative $492 billion in 2005 to negative $136 billion in 2018. 

“U.S. exports of petroleum products have steadily risen, increasing fivefold to 5.0 mb/d since 2006. In recent years, the U.S. has also become a major exporter of crude oil, with exports rising from less than 0.5 mb/d in December 2015 to 3.0 mb/d in July 2019.” 

The significance of the shale revolution is shown in its contribution to U.S. oil production from 2000 to 2019.  From 2010, shale output exploded, while non-shale production declined.  As Exhibit 12 shows, Gulf of Mexico production began increasing in 2013, and surpassed its prior high of 2016.  That output increase was directly tied to the ending of the 2010 Gulf of Mexico moratorium on drilling and the natural lag time from the industry restarting activity until production began rising.  We also see Alaska oil production in a steady decline throughout the entire period. 

Exhibit 12.  Shale Production Growth Dominates Oil Output

Source:  Dallas Fed

Another contribution of the oil and gas industry was turning the United States into an oil exporter.  While the Dallas Fed working paper pointed out shale’s impact on U.S. oil imports, the role of growing exports was only briefly touched on.  The growth in U.S. exports disrupted the functioning of the global oil market and its control by OPEC, as well as its leader Saudi Arabia.  U.S. exports helped drive down global oil prices, a decline amplified by the actions of Saudi Arabia and Russia in boosting their output and exports just at the moment Covid-19 was destroying oil demand.  The growth of U.S. oil exports altered the geopolitical balance, boosting our influence, especially in the Middle East.  Those changing dynamics likely contributed to the recent Israel-United Arab Emirates peace agreement, known as the Abraham Accord. 

Exhibit 13.  Shale Boom Boosted Oil Exports

Source:  Dallas Fed

In the thinking of the stock market, none of the importance of the oil and gas industry’s economic or international geopolitical contributions matters.  The disdain of investors for oil and gas stocks has been evident for years.  We can see that in several charts.  The first (Exhibit 14) shows, by color, which sectors of the Standard & Poor’s Index preformed, ranked from best to worst, from 2007 through the first half of 2020.  What one sees is that of the 14 time periods, energy ranked in the bottom three sectors eight times, of which it was the worst performing sector five times.  Looked at by performance versus that of the S&P Index, energy outperformed five times, with top performance in 2007 and 2016.  Obviously, this record for the energy sector is not positive for attracting new investors, let alone retaining investors. 

Exhibit 14.  Energy Has A Dismal Investment Record

Source:  S&P, PPHB

Another measure of energy investor abandonment of the sector is seen through the long-term record of sector weighting in the S&P 500 Index.  The energy sector is now at an all-time low weighting at slightly under 2.5%.  What Exhibit 15 shows is that from the all-time peak in 1980, with brief upticks in the interim, the weighting bottomed around 5% of the index in the early 2000s.  At that time, the soaring oil price and the perception of global oil shortages signaled that energy’s fortunes were changing.  That upturn lasted until the Great Recession, which seems to have marked the next shift in investor sentiment toward energy’s future that has led to the extremely low level of today. 

Exhibit 15.  Can Energy Recover Positive Investor Sentiment?

Source:  S&P, PPHB

It is interesting to examine the relationship between the S&P 500 Index energy weighting and the real price of oil.  Exhibit 16 shows how closely the energy weighting decline during 1980-2003 was a reflection of the trend in real oil prices.  What is interesting is that for

Exhibit 16.  Recent Oil Price Collapse Hurts Energy Weighting

Source:  S&P, EIA, BLS, PPHB

much of the post-2007 period the relationship hasn’t existed.  When oil prices soared from $40 to $100 per barrel between 2009 and 2014, the energy sector weighting declined, other than for a brief uptick in 2010.  The rate of decline in the weighting appears to be steady from 2010 to late 2019, but the recent drop appears to reflect this spring’s oil price collapse. 

The removal of ExxonMobil from the DJIA is a reflection of investor views of energy’s future, or at least that of traditional oil and gas.  It is also a reflection of the current “love affair” of investors with technology stocks, and in particular a small number of prominent tech companies.  Investors may be underestimating the resiliency of oil and gas, and its history should be a reminder.  Moreover, stocks removed from the DJIA have often outperformed after the event.  The following observation is intriguing:

"According to the WSJ Market Data Group, the average performance one year after being added to the Dow is minus 8%, while the return is almost flat — negative 0.6% — after ejection. The performance differential is especially notable more recently: The last five changes have seen a 3% rise for additions and a 43% rise for those stocks exiting."

Oil and gas will continue playing a significant role in meeting the world’s energy needs for decades.  That fact is ignored by investors, but every realistic projection shows it to be the case.  However, the industry is unpopular with many in today’s society, and especially a number of leading investment professionals.  The media’s approach of conjuring up images of wildcatters and an industry that is arrogant, cares little about the environment and the little guy, and is only interested in profits, doesn’t help.  People fail to understand the amount of technology imbedded in the oil and gas industry, and how it can be used to create a cleaner energy world and lift people from poverty.  None of that helps energy’s image or share prices.  The reality is the industry’s future is not as dire as portrayed in the stock market, but investing in energy stocks is swimming against the tide.  There are scenarios where the industry recovers and the stocks do better, but at the moment those scenarios are given little chance of happening.  Only optimists or real contrarians are interested in energy stocks at the moment, but stay tuned. 

A major topic in investment circles and corporate board rooms is the issue of environment, social and governance (ESG) metrics.  Much like the climate movement’s evolution from global heat measures to now all aspects of unusual climate trends that can be extrapolated to show horrific economic and social outcomes, ESG is rapidly making a similar transition. 

The issue of ESG is directed at public corporations, as some offer easy, high-profile targets that help the movement score victories.  Leaders in this effort are the mutual funds and exchange-traded funds (ETF) that only invest in companies with high ratings for ESG.  Whether these funds actually outperform traditional mutual funds and ETFs has become a battleground for investment experts.  However, one wonders whether the promotion of ESG investments is an attempt by money managers (many now publicly traded companies) to capitalize on the generational transfer of wealth underway to concerned youths.  Larry Fink, the head of the world’s largest money manager BlackRock, has often highlighted how he expects ESG-focused ETFs will see $400 billion of inflows by 2028, up from $25 billion last year.  To capitalize on this trend, BlackRock is planning to dramatically increase the number of ESG oriented ETFs it offers investors as a way to boost its income. 

Governance has always provided an attractive target for corporate critics and activists because there have been serious improprieties.  Many governance issues arise when insiders and complicit directors engage in actions detrimental to the interests of shareholders, but they are also often detrimental to the interests of other groups – employees and local communities.  Many of these violations are uncovered by securities regulators, but it often has taken activist shareholders to highlight them.  A beacon leading to activist interest is severe investment under- or overperformance. 

While the most blatant examples of governance failures are easy to dismiss as one-offs, the ESG challenge goes well beyond improprieties and to the question of risk management for corporations.  Public companies are cautioned to always highlight for investors the risks to its future performance, as protection against lawsuits if something does go wrong.  These warnings are usually incorporated in the first slide of investor presentations, and are written in terse legalese and conclude by directing investors to the company’s financial filings with regulators.  The “Disclaimer” slide is laughingly referred to by company presenters at investment meetings as “a message from our lawyers,” or “this warning tells you to not believe anything I say during this presentation.” 

In financial filings, companies are required to list all the factors that could possibly harm the company’s financial health and its future revenue and earnings performance.  The reason for this requirement is for a legal defense if something goes wrong and the company’s share price is significantly damaged.  As climate change and social inequity concerns have grown in recent years, the younger population segment (Millennials) has become energized and is demanding that society, governments and corporations address these challenges.  For corporations, the pressure is to actively respond by altering how they have been managing and investing, and adopt a management philosophy that incorporates responses to all these social concerns. 

Utilizing ESG as an umbrella to capture the social concerns, the financial community is now selling investment products that should appeal to these young, socially-concerned investors.  While most investment firms are targeting Millennials, a Wall Street Journal article in late 2019 addressing ESG investing by age groups stated that Millennials are the most vocal about ESG, and have increased their frequency of checking their portfolios for ESG resiliency.  But, according to investment brokers, it is Gen Xers who are investing more money in line with ESG guidelines. 

Exhibit 17.  How Is Most Concerned About ESG?

Source:  The Wall Street Journal

The hope of investment firms is that as younger investors grow their wealth, plus benefit from the wealth transferred from their Baby Boomer parents, ESG funds will benefit.  To support that view, data from Kasasa, a financial and technology services company, shows the generational breakdown by age and their net worth:

• Baby Boomers: Baby boomers were born between 1946 and 1964.  They’re currently between 56-74 years old (71.6 million in U.S.) and have an average net worth of $1,066,000 and a median net worth of $244,000.

• Gen X: Gen X was born between 1965 and 1980 and are currently between 40-55 years old (65.2 million people in U.S.).  They have an average net worth around $288,700, but the median is $59,800.

• Gen Y: Gen Y, or Millennials, were born between 1980 and 1996.  They are currently between 24-39 years old (72.1 million in the U.S.) and have an average net worth around $76,200, but a median net worth of only $11,100.

• Gen Y.1 = 25-29 years old (around 31 million people in U.S.)

• Gen Y.2 = 29-39 (around 42 million people in U.S.)

• Gen Z: Gen Z is the newest generation to be named and were born between 1996 and 2015.  They are currently between 5-24 years old (nearly 68 million in U.S.).  It is difficult to report on this generation, as they have no net worth or career.

Recently, a battle has erupted over the performance of ESG-focused funds.  Earlier this year, BlackRock pointed out that sustainable (ESG) investment funds outperformed other funds in the market downdraft due to the Covid-19 outbreak.  BlackRock noted: “In the first quarter of 2020, we have observed better risk-adjusted performance across sustainable products globally, with 94 percent of a globally-representative selection of widely-analyzed sustainable indices outperforming their parent benchmarks.”  They further stated: “Overall, this period of market turbulence and economic uncertainty has further reinforced our conviction that ESG characteristics indicate resilience during market downturns.” 

BlackRock also noted that the market sell-off in March spurred investors to rebalance their portfolios, which included increasing their exposure to ESG.  A HedgeWeek article noted that BlackRock highlighted how global sustainable open-ended funds drew $40.5 billion in new assets during 1Q20, a 41% increase year-over-year.  The potential for ESG investing growing in the future was reinforced by BlackRock’s statement that “In this volatile environment, investors have been seeking to understand what characteristics contributed to comparative resilience in portfolios and how to incorporate these characteristics in their own investments.” 

Data from several investment firms highlight the performance record of sustainable (ESG) investments.  While they did not match the market during 2015-2020 (ending April 20), they outperformed non-ESG funds.  These funds outperformed both the broad market and non-ESG funds for 2017-2020, and they have produced positive returns for 2020, year-to-date.  These funds also did not fall as much as the market and non-ESG funds for February through April 2020.  The latter performance would appear to support BlackRock’s view that 94% of ESG funds outperformed the broad market index during the first quarter of 2020. 

Exhibit 18.  How ESG Portfolios Have Performed

Source:  Visual Capitalist

The second chart in Exhibit 18 (prior page) shows selected ESG funds offered by Fidelity International (blue) and how they did not decline as much as the broad market or the non-ESG funds during February 19 to March 26, which captured the worst of the stock market downturn this year.  With the market having recovered and now reaching new highs, it will be interesting to see how the fund comparisons are at the end of 2020.  JP Morgan said that 55% of global investors believe that Covid-19 will be a positive catalyst for ESG investing.  That view supports the estimate that $45 trillion of assets will be invested under ESG principles by the end of 2020. 

The ESG fund performance claims have come under attack, most recently in a report by four business school professors from both sides of the Atlantic.  The professors acknowledged the claims of ESG outperformance. 

“‘Responsible investment’ fund managers and ESG data purveyors alike have been perpetuating the reputation of ESG as a resilience factor, with Morningstar even referring to ESG as an “equity vaccine” against the pandemic-induced market selloff (Willis (2020)).  For example, for the first quarter of 2020, Blackrock, the largest active investor in the world, reported better risk-adjusted performance across sustainable investment products globally (Blackrock (2020)), Morningstar claimed that 24 of 26 ESG-tilted index funds outperformed their closest conventional counterparts (Hale (2020)), and MSCI boasted that all four of their ESG-oriented indices outperformed a broad market counterpart index (Nagy and Giese (2020)).  Following all of this hyping of ESG as downside risk protection, there was no surprise in CNBC’s report that the first quarter of 2020 saw record inflows into sustainable funds (Stevens (2020)).  Despite this high level of enthusiasm, however, skepticism is beginning to emerge about whether ESG really serves as a returns shield in times of crisis.”

The comment about skepticism was noted in footnotes, which are worthy of attention.  The most relevant footnote stated:

“For example, the Wall Street Journal recently attributed higher ESG firms’ pandemic returns outperformance to luck (Mackintosh (2020)).  And a Financial Times article similarly suggested that ESG-titled bond indices’ outperformance during the COVID-19 selloff was not due to ESG per se, but rather because the underlying firms had higher credit ratings and the funds had low exposure to the energy sector that was hit by a contemporaneous crash of historic proportions (Nauman (2020)).”

The professors’ study involved a detailed examination of all the variables that impacted stock performance during 1Q20.  The professors described the study:

“We first perform a multiple regression analysis of stock returns during the “crisis” quarter (i.e., January through March 2020).  Specifically, we regress buy-and-hold abnormal returns on the firm’s ESG scores, after controlling for numerous other factors such as accounting-based measures of financial performance, liquidity, leverage, intangible asset investments, variables capturing institutional investor interest and shareholder orientation, firm age and market share, the firm’s industry affiliation, as well as a full array of market-based variables that are known determinants of returns.” 

The study’s conclusion about the contribution of variables impacting stocks’ performance during 1Q20 is shown in Exhibit 19.  The stocks’ risk and growth potential are the variable explaining the largest amount of performance, followed by industry and company financials.  ESG, however, only contributed 1% to the performance.  That would certainly call into question the belief that ESG variables helped funds and stocks to outperform.  As the professors pointed out, many of the outperformance claims are really based on simple pairings of funds, and not analyses holding variables constant to understand what is the contribution of a particular variable. 

Exhibit 19.  ESG Contributed Only 1% To Performance

Source:  Professors’ Study

The professors decided to give ESG a second chance, so they conducted a similar analysis for 2Q20, which they considered to be a recovery.  Here is what the study concluded. 

Exhibit 20.  ESG Meant Little To Rising Share Prices

Source:  Professors’ Study

As the authors put it, “The results from this second chance test indicate that firms’ ESG scores are significantly negatively associated with returns during the market’s recovery, while their investments in internally generated innovation-related assets are once again positively associated with returns to an economically significant degree.”  The results from this period of a rising stock market, coupled with the results during the downturn, certainly point to other company characteristics having greater influence in performance than ESG scores.  These results will do little to blunt the ESG movement, and in Europe it is very strong.  It recently led one money manager in Norway to sell all its coal and oil and gas stock holdings.  They join many other European-based money management firms that are eschewing fossil fuel investments to demonstrate their commitment to ESG. 

The major way that ESG is helping to change global corporate culture is via climate change.  Having convinced governments that only they can prevent the damages from climate change, politicians have embraced bans on fossil fuels and requirements that future power come from clean energy.  As politicians often do, they embrace the broad intent of policy changes, but never investigate the social and/or economic costs and disruption, or, in other words, what the downsides of the policy changes might be.  We have seen that shortcoming in California with its rolling electricity blackouts to prevent the entire electric system from crashing during the heat wave, caused by relying too much on renewable power.  Proponents of clean energy – solar and wind – are now acknowledging that California doesn’t possess a “smart” electric grid.  Such a grid would be able to draw electricity from individual home solar panels and to shut down air conditioners and other large electricity consumers when peak demand arrives.  This will take years and cost billions to create.  Did they possibly put the cart before the horse? 

At the same time these people are bemoaning the lack of a smart grid, they are happy to see subsidies offered to suppliers of clean energy and large power consumers, such as electric vehicles.  While similar conditions exist in Europe, their experiences have not received as much media attention as in California.  The UK heat wave resulted in a drastic drop in wind power’s contribution, and when the sun went down, so too did electric power supplies.  Continental Europe hasn’t experienced a serious heat wave, plus there are many more countries that can provide surplus energy, so they have avoided similar experiences.  But, as European economies are on track to reduce, and eventually eliminate, fossil fuel use over the next 20-30 years, traditional energy providers are rethinking their business models and strategies.  While many of these managers understand that the clean energy policies being put in place may not be met, they also understand that their fossil fuel demand is being capped, and it will shrink in the future.  How quickly the market shrinks is unknown, but it will shrink, until it doesn’t.  At the same time, not all countries served by these companies are on the same course, which makes investment decisions tougher to not wind up with stranded assets that destroys financial returns. 

Caught in the squeeze between ESG pressures from investors and increased pressure from environmentalists and policymakers to curtail their basic businesses, there aren’t any escape routes.  That is why we see those European-based major oil companies leading the charge in curtailing their traditional oil and gas activities and increasing their green energy investments.  The result, however, is as Bernard Looney, the CEO of BP plc, warned last February, during his first public press meeting, that green energy investments do not earn returns anywhere close to those of traditional oil and gas operations.  As a result, he warned investors in BP stock to recognize that their dividend checks might not grow at the same rate they have in the past due to a greater investment in lower return renewable energy projects. 

Lower returns are certainly a risk from the shift to renewables and clean energy investments.  While this will play a role in overall investor returns, the push for ESG may have a greater impact.  Will companies that don’t screen well on ESG metrics be valued lower than before?  Contrarily, those top-ranked ESG stocks might sell in the future at a premium to their current valuations, as investors and fund managers clamor to fill their portfolios with socially acceptable investments.  What might these investment shifts mean for executives in how they manage their companies.  The professors who authored the ESG study referenced above warned:

“An alternative view of corporate ESG investments suggests that executives may choose to improve their company’s ESG scores at the expense of shareholders in order to build their own personal reputations.  From this agency theory perspective, ESG investments are at best wasteful, and probably even harmful to shareholders (e.g., by increasing the propensity for management entrenchment).”

Based on that possibility, it is not inconceivable that managers might actually reduce the resiliency of their companies, while also lowering their ESG credentials.  How often is the composition of ESG funds re-evaluated and shareholdings rebalanced?  Therein lies a risk to ESG investing.  That risk is added to the lack of true ESG standards and complete disclosure of company ESG variables.  This lack of corporate disclosure and inconsistency among companies is why investment fund managers in Europe are pushing back hard against the EU’s push to develop the world’s first rulebook for sustainable finance, of which green bonds are expected to be a major component, as well as ESG investing. 

The European Fund and Asset Management Association (EFAMA) has written to EU regulators asking for more time for the industry to gather information about the ESG risks in their portfolios.  As a central plank of the EU’s push to fund the green transition, the ESG disclosure regulations aim to limit “greenwashing” by forcing asset managers to provide clear information about the sustainability of their portfolios.  The rules are to be in place in March 2021, but the EFAMA is asking for a delay until January 2022 at the earliest.  They point out that many of the data points required by the regulations are not available, plus companies are unaware of the new regulatory requirements, therefore they do not have the necessary data.  The pushback from the investment industry points to the gulf between policymakers’ ambitions for green finance and the thorny reality of implementing a new system from scratch.  Once again, a rush to institute policy without considering what it takes to implement it. 

While ESG is popular today, the reality is that CEOs and boards of directors pay attention to the welfare of all their stakeholders.  It is difficult to deliver outstanding results while mistreating stakeholders.  In essence, this appears to be the conclusion of the study by the business school professors.  This isn’t the first, nor will it be the last time a popular stock market fad drove investing strategies.  With Millennials driving ESG popularity, and they represent the future wealth holders, investment funds are bound to dream up ways to get their hands on that wealth.  To a large degree, the clamor over ESG investing may be nothing more than a marketing ploy.  The question is whether an ESG investment philosophy shortchanges Millennials when they will need the money to support their retirements. 

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Parks Paton Hoepfl & Brown is an independent investment banking firm providing financial advisory services, including merger and acquisition and capital raising assistance, exclusively to clients in the energy service industry.