Divest or be damned?

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Torn between the lure of healthy dividends and the rising importance of ESG¹, income managers find themselves on the horns of a dilemma when it comes to oil and gas majors, says Newton income fund manager Emma Mogford.

Understanding the energy sector has always been a big ask. Even in the best of times the nexus of pricing, demand and output makes for a moveable feast where even seasoned experts can get it wrong. Today, as concerns about climate change move ever further up the political agenda, the question of stranded assets² adds complexity to an already complicated question.

So, how should investors respond? Is there a magic bullet to help them understand what value they should attach to oil and gas companies in a world of rising CO₂ – or more radically should they divest altogether?

Certainly the question of divestment is a topical one, says Emma Mogford, manager of Newton’s UK Income strategy – and, already, many asset owners are heading for the exits.

To take just one example, 69 UK universities, along with Cambridge colleges Peterhouse and Queen’s College, as well as two Oxford colleges, have divested either fully or partially from fossil fuels.³ Meanwhile, oil and gas companies themselves are engaged in a Battle Royale over their ESG credentials – each competing ever more fiercely to be seen as greener than green.

Past and future oil demand

Source: BP, International Energy Agency; Financial Times. March 16th 2019

¹ Oil demand has increased by 30% over past 20 years but the IEA’s sustainable development scenario (SDS) notes demand will need to fall by the same amount if climate change is to be limited to 2°C.

For Mogford it all adds up to a complicated situation where there is no simple answer. On the one hand, oil and gas companies remain intensely profitable. Notwithstanding the progress made on renewables in recent years, oil, gas and coal are still the primary energy source for the vast majority of people on the planet. According to international energy analyst BloombergNEF, global electricity demand is set to increase 62% by 2050, resulting in global generating capacity almost tripling between 2018 and 2050.⁴ Renewables may make a dent in that demand but traditional sources of electricity generation will still be on the hook.

At the same time, fossil fuels provide the only reliable feedstock for the plastics industry – and, as yet, there is no practical alternative to this. Similarly, in the absence of a technological fix, fossil fuels are unlikely to be replaced as the go-to energy source for the world’s planes, ships and trucks any time soon.

The outcome of all of this can be seen in the numbers. Saudi Aramco, the world’s largest oil company, books a daily profit of more than US$304m – equivalent to US$3,519 a second – making it the world’s most profitable company by far.⁵ Against this, Royal Dutch Shell, the world’s eleventh most profitable company, pales into insignificance, booking a mere US$63m a day or US$740 a second.⁶

And yet, says Mogford, there is little question that the momentum away from fossil fuels is gathering pace. In June 2019, the UK government pledged to cut greenhouse gas emissions to almost zero by 2050⁷; California claimed to have already hit its target of a 40% reduction in carbon emissions by 2030 (from 1990 levels).⁸

On the corporate level, the Task Force on Climate-related Financial Disclosures (TFCD) has created a framework for companies and countries to begin to understand the likely financial costs of climate change. Sooner or later, says Mogford, governments will begin to get involved, most likely by imposing penalties on the largest emitters of CO₂.

In a world where government policy can have a profound effect on companies’ valuations it’s absolutely crucial that investors start now to work out what the impact of legislation might be,” she says. “We do think governments around the world will begin to act to try to limit climate change to 2°C. That’s the good news. But we also think any action will take time and, more importantly for investors, it will be very difficult to gauge how those actions will affect the value of their holdings.

For Mogford, part of the solution is a combined effort by fund managers, analysts and ESG specialists to model the possible impact of climate change on the energy sector. “The IEA, for example, has suggested oil demand will need to fall by about 30% by about 2040 if we want to reach that 2°C climate change target,” she says. “Internally, we wanted to try to understand whether that’s feasible, and, if so, whether oil companies are able to sustain the cheaper oil price that would entail. As always in the energy sector, there will be times when oil and gas companies are too expensive; there will be times when they’re too cheap. But by modelling the possible impact of climate change-related regulation we can begin to work out a long-term investment case well ahead of the game and tailor our allocations accordingly.” In the meantime, investment managers can make more of a difference through engagement than divestment, says Mogford.

It’s good to talk: Cumulative abnormal returns after engagement with 613 US companies 1999-2009

Cumulative abnormal returns chart

Source: Dimson, Li and Karakas (2015), Centre for Endowment Asset Management, (study of 613 US companies, 1999-2009). For illustrative purposes only.

We’d love to say: we’re totally divested out of the oil and gas sector – but it’s much more nuanced than that. The evidence suggests that maintaining your holding and talking to companies can actually be the more powerful choice.

Already, partly in response to shareholder pressure, she notes, oil and gas companies have been making efforts to reduce their CO₂ burden – using relatively straightforward initiatives such as reducing gas flaring in oil fields, upgrading to more efficient refineries, for example, or decarbonising their transport systems.

Admittedly, says Mogford, these initiatives barely scrape the surface – but there is far more companies could do, should sufficient pressure be brought to bear. Oil and gas majors, for instance are well-placed to become leaders in the field of carbon capture, using legacy assets such as depleted gas wells. They also have the infrastructure and technological know-how to take part in large-scale production of hydrogen using renewable energy. By nudging companies in the right direction, says Mogford, ESG-aware shareholders can actually make far more of a positive impact than if they sell their holdings and allow less scrupulous players to take their place.

As with tobacco, so with oil?

Looking further forward, Mogford makes a comparison between oil and gas companies and the tobacco industry in the second half of the twentieth century where, year after year, decade after decade, the regulations around the manufacture and sale of tobacco products gradually built up.

And yet, year after year, decade after decade – even after all the health risks were established and well known – tobacco companies remained intensely profitable, with the decline in smoking running at only around 4% annually,” she says. “Arguably it was only technology – the invention and widespread adoption of vaping technology in the past decade – rather than regulation or health concerns that undermined profitability and so made the tobacco industry less of a focus for income managers.

Mogford believes today’s energy majors could be in a similar place to the tobacco producers of yesteryear. Yes, they may be vilified, she says – and, yes, the pressure for investors to head to the exits may continue to grow, but in the meantime they will continue to book profits. “Ultimately, investing in them could become untenable but, until that tipping point is reached, complete divestment is not automatically the right choice,” she concludes.

¹ ESG investing focuses on environmental, social and governance concerns.
² In this context, the term stranded assets refers to fossil fuels such as oil, gas or coal which are no longer economically viable given the costs associated with climate change.
³ DeSmogUK: ‘Mapped: The UK Universities that have Pledged to Divest from Fossil Fuels’, 13 April 2018
BNEF: ‘New Energy Outlook 2019 (NEO)’, 18 June 2019
⁵ Apple comes second with ‘just’ US$163m a day.
⁶ Visual Capitalist: ‘The World’s 20 Most Profitable Companies’, 21 October 2019
BBC: ‘Climate change: UK government to commit to 2050 target’, 12 June 2019
LA Times: ‘California hit its climate goal early — but its biggest source of pollution keeps rising’, 23 July 2018.

The value of investments can fall. Investors may not get back the amount invested. Income from investments may vary and is not guaranteed.

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