Oil and ESG investing don’t mix – on this subject a number of observations.
First off, I’m not a massive fan of ESG investing and it certainly doesn’t feature in my portfolio allocations but I’m also realistic enough to know that large weight of institutional money is increasingly being run through ESG filters. And on one level I can understand why – if you are a long-term investor, you should care about the overall sustainability of the business model. My qualms centre more on the screening process and check box approach of many ESG specialists.
Next up, I do think there is a huge issue about the oil industry and all that black stuff in the ground. Again, I do NOT think that we are about to kick the hydro carbon habit any time soon. The recent debate around electric cars and the supposed demise of the internal combustion engine (ICE) is a case in point. I DO think we are seeing the first stages of a huge revolution in the energy infrastructure of the developed world. I DO think we will see many more electric cars on the road. But I also think that the ICE will survive and prosper in new iterations over the next few decades. Fuel efficiency is shooting up and for heavy loads such as lorries and plant machinery I see no realistic alternative. But this caution should not underestimate the massive changes coming down the track around oil. I do NOT believe in a boycott of oil shares but I DO think investors might need to increasingly discount the value of those oil reserves. I also think the divestment movement will have an impact – for right or wrong – and investor’s need to be cautious about this.
Lastly the temptation is to regard all oil companies as hopelessly morally bankrupt. I’s not that difficult for instance to be horribly cynical about the green rebranding exercise pursued by Lord Browne at BP a while back (remember Beyond Petroleum). But it expressed a real strategic need to change tack over the next few decades. As I said the temptation is to just laugh it all off, cynically, suggesting that all the energy majors are doomed. But they need to change their business models and surely, as investors, we should encourage them to build a more sustainable strategy which will generate the required profits. In effect, this is a plea for working with energy majors to make them better, more sustainable businesses. In an ideal world, it may also help reinforce their share prices.
So, it’s against this background that I saw a report this week from Hermes on the oil industry. I have a huge amount of respect for Hermes and the work they do on ESG investing. They’re thorough and professional and I suspect if anyone has thought about how to make an oil investment more sustainable they have. But what really struck me was the choice of businesses in their report – two developing world Latin American outfits, Pemex and Petrobas.
The report is by Audra Stundziaite, Senior Credit Analyst, and Jaime Gornsztejn, Associate Director, Hermes EOS and it sensibly focuses on the need to engage with both businesses by focusing first as credit investors.
According to Stundziaite and Gornsztejn Petrobras and Pemex – ranked 10th and 8th respectively in terms of global oil production – benefit from substantial scale, low costs of production and implicit government support. Both have also boosted their performance and reputations by embarking on material strategic refurbishments – obviously both also have traditionally had a fairly poor reputation amongst most mainstream investors, especially those investing bonds.
Here’s Hermes verdict, quoted at some length starting with Brazilian giant Petrobas, subject of the massive local corruption scandal.
“The company began ramping up production from 2008 after making major oil discoveries in offshore pre-salt fields. To exploit its discoveries, Petrobras more than quadrupled its borrowing levels over the next five years to a peak of about $140bn in 2014, compared to just $30bn previously. In the process, the company increased its leverage ratio from one-times to five-times. While Petrobras has eased off the debt-pedal somewhat since 2014, its current borrowings of roughly $114bn mark it out as the largest constituent of the Global High Yield Index. With leverage rising faster than production, mounting interest costs put extreme pressure on Petrobras’ cash flows by 2015, ahead of the $12bn in principal payments it was due to pay in 2016. Unfortunately, the Petrobras debt squeeze coincided with slumping oil prices and, to the further dismay of investors, a major corruption scandal flowing into the public domain.
As far back as 2012, Hermes’ stewardship and engagement team EOS has pressed for board changes at Petrobras that would see the independent directors take up the two seats reserved for minority shareholders that were not closely linked to the government. Historically, the Brazilian government had stacked the Petrobras board by appointing nine of the 11 seats and allowing minority shareholders – including state-controlled pension funds – to vote for the remaining two.
However, in 2013, after a period of intense negotiations, Hermes EOS and a group of international investors were successful in seeing their two independent director nominees elected to the Petrobras board. By the 2015 AGM, at the height of the Car Wash scandal, the Brazilian government itself put forward independent board directors in lieu of the traditional state appointees. In addition, Petrobras’s new corporate strategy, which was revealed in September 2016, emphasises debt reduction and focuses on targets that include:
- Reducing leverage to 2.5-times by the end of 2018;
- Selling $21bn of assets by the end of 2018;
- Pursuing partnerships and joint ventures, which are projected to reduce capex burdens by 25% by 2021;
- Increasing cash flows by improving efficiency and reducing headcount; and
- Reducing accident rates.”
According to Hermes “Petrobras still has some work to do but these initiatives have already struck pay dirt, as demonstrated by the following achievements:
- Leverage has declined from 5-times in the second quarter of 2016 to 3.15-times a year later;
- Free cash flow has been generated for the last five consecutive quarters; and,
- Moody’s upgrading Petrobras debt from B3 up to B1 with positive outlook.
“Pemex: Seeking sustainability
North of the Brazil border, Mexico’s Pemex – or Petróleos Mexicanos – has experienced some of the same problems as Petrobras, namely: high debt levels and government interference in its commercial operations. Unlike Petrobras, it is wholly owned by the government.
Unfortunately for investors, ESG concerns entered the frame. They included: Pemex’s significantly below-par record on workers’ safety, and a poor environmental management history that featured numerous oil spills and leaks. To discuss these matters, we asked Hermes EOS to initiate conversations with Pemex. To its credit, the company was keen to take up the dialogue.
In particular, our discussions with the company’s sustainability team in May 2017 went some way to reassuring us about its commitment to better ESG practices. From this engagement, it was clear that Pemex was aware that it needed strong ESG performance to attract discerning investors in global debt markets. With the Mexican energy sector undergoing deregulation, Pemex can focus more on expansion and less on supporting the federal budget. Best-practice management of its operations will enable it to become more competitive.
The company has made some progress in lifting workforce health record to industry standard, citing a recent workplace safety campaign that mandated ‘zero tolerance’ for risky behaviour. Moreover, labour safety and carbon-emission-reduction targets have been published in its five-year business plan ending in 2021.
These actions to date augur well for Pemex, but we will continue to monitor the company against its stated ESG targets. We would certainly consider moving to an above-benchmark position in Pemex debt if it reduces ESG risks as planned – assuming, of course, the group’s credit profile remains stable and valuation sensible.”