The energy sector continues to play an essential role in the functioning of the world economy. Its role in investors' portfolios has been diminishing, however, and some investors see the energy sector as the antithesis of responsible investing. BENJ BAHR, senior analyst on the Global Value team, explains why we do not agree.
Q: Environmental concerns—air quality, water quality, climate change—are driving some investors away from the energy sector. Why does First Eagle still have oil and naturalgas companies in its portfolios?
Benj: 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 fuels are the lowestcost resource, and coal, oil and natural gas still supply about 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, fertilizers and fuels for commercial vehicles and airplanes. In normal travel years, aircraft account for about 10% of all oil demand and that percentage is growing, and 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 roughly one-third of oil exports. Iran, Nigeria and Venezuela, which are also major exporters, represent close to 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 supply 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 broadscale 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 fully divest from fossil fuel stocks have contributed to our belief that there may be attractive opportunities in some energy stocks.
Q: Many countries have agreed to reduce their use of fossil fuels. How does this affect your thinking about the energy sector?
Benj: 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 in their vehicles, and fossil fuels are currently powering most of the charging stations. Renewable sources of energy have become cheaper over time, but wind and solar power still typically require government subsidies to compete with fossil fuels on the basis of price.6
We do not underestimate the 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.7,8 Historically, energy transitions have lasted for decades, not years.
Q: How do you think about sustainability in the context of the energy sector?
Benj: 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 acknowledging the risks that are ahead it is more likely to adapt to changes within the industry. Likewise, if a company consistently seeks out best practices, we believe it is more likely to have the ability to 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 advantages. We want to see companies that think about the environment because they are looking out 10 or 20 years into the future, and they are 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. They are good actors from a regulatory point of view, but when it comes to business performance, they are aligned with the interests of shareholders. For them, sustainability is not an end in itself, but a means to an end.
Further, in thinking about ESG risks to energy companies, it is important to keep in mind that not all fossil fuels are created equal. Although there are environmental 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 substitute for other fossil fuels.
Q: What have energy companies in your portfolios done to address ESG risks?
Benj: Many of the companies we own are heavily focused on efforts to address environmental risks. ExxonMobil (XOM, Financial) is a good example of that. The company wants to be part of the solution in the energy transition, and it is spending about $5 billion a year on environmental issues and more than a billion dollars annually on research into everything from more environmentally friendly resource extraction to the production of biofuels. It employs 2,300 PhDs.9
As a large-scale, low-cost, technically advanced organization with extensive resources, Exxon is a natural partner to academic institutions and nonprofits in applying new technologies going forward. We have been favorably impressed by recent changes at Exxon, such as its selection of new board members, its more open communications policy and its willingness to lead on climate issues. Few companies in the world—and not many governments—have as great a capacity to address environmental issues. And while it is popularly known as an oil company, in reality it has built its presence in natural gas, refined products and chemicals to the point where these now account for roughly half of Exxon's earnings.10
When making investments in any sector, including energy, we examine the incentives a company's board has implemented to motivate management behavior. In ExxonMobil's case, the board has created incentives that are aligned with the company's longterm orientation. Members of the management team are paid in stock on the basis of metrics like shareholder returns and returns on capital, with compensation vesting over a 10-year period. This aligns them with shareholders on a long-term basis.
Q: Have you invested in any renewable energy companies?
Benj: 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 generally 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 potentially make money from that with the help of tax benefits or other subsidies for their power output. The technology for renewables is becoming compelling, and we do not dismiss them. But we want to invest in companies that can pay us a dividend, conduct stock buybacks and create shareholder value over time. We don't currently expect that many renewables companies will be able to do those things in the near-term or mediumterm. That said, we continue to pay close attention to renewables as we think about the long-term prospects for the energy sector.
Q: How much weight does sustainability carry in your investment process?
Benj: We view our value to society as preventing impairment of 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 lives. 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.
1.,2. Source: International Energy Agency.
3. Vaclav Smil, Power Density: A Key to Understanding Energy Sources and Uses, MIT Press (2016).
4. Source: International Energy Agency.
5.,8. Vaclav Smil, Power Density: A Key to Understanding Energy Sources and Uses, MIT Press (2016).
6. Source: Levelized Cost of Energy and Levelized Cost of Storage, Lazard (2020)
7. "Eternal Flames? Three Centuries of Energy Transition," Redburn (February 2018)
9. Source: Exxon Mobil Annual Report, 2019 and 2020.
10. Source: Exxon Mobil Annual Report, 2020. Exxon Mobil Financial & Operating Data Reports, 2015-2020.
Past performance does not guarantee future results, which may vary. The value of investments and the income derived from investments will fluctuate and can go down as well as up.
Environmental, social and governance (ESG) issues may be factors, among many, that are considered as part of our fundamental research process. We do not seek to invest in companies based on ESG criteria.
All investments involve the risk of the loss of principal. The principal risk of investing in value stocks is that the price of the security may not approach our estimate of its intrinsic value or may decline in value.
There are risks associated with investing in securities of foreign countries, such as erratic market conditions, economic and political instability and fluctuations in currency exchange rates. Investment in gold and gold-related investments present certain risks, and returns on gold-related investments have traditionally been more volatile than investments in broader equity or debt markets.
The commentary represents opinion as of May 2021 and is subject to change based on market and other conditions. The opinions expressed herein are not necessarily those of the firm. These materials are provided for informational purposes only. These opinions are not intended to be a forecast of future events, a guarantee of future results or investment advice. Any statistics contained here have been obtained from sources believed to be reliable, but the accuracy of this information cannot be guaranteed. The views expressed herein may change at any time subsequent to the date of issue hereof. The information provided is not to be construed as a recommendation or an offer to buy, hold or sell or the solicitation of an offer to buy or sell any fund's shares or security.
