I recently had a chat with my 19-year-old son about investing in energy stocks. He has just opened a Freetrade account and is already showing signs of being a thoughtful investor. Not for him all the bonkers stuff in the crypto space – he is much more interested in solid businesses. In fact, he’s even showing signs of being something of a contrarian, which is rather amusing I must say.
Anyway, a while ago he asked me about investing in Exxon. I ummed and ahhed . I could see his argument but was not convinced. In a simple sense, he has correctly identified that energy stocks are a classic value, contrarian play but he’s more interested in a longer-term investment horizon. He wants to know if the sector he invests will be around in a few decade’s time. I mumbled something about “who the heck knows”, but felt that I hadn’t really answered his question. Which was, “are mega large-cap energy stocks a long term buy?”.
This is a different argument than the one which says energy stocks are cheap now and that oil prices might rise. It is also a different argument from the moral one, which is whether you should be investing in oil companies now. To which I suppose one would be no.
The real argument is more complex and addresses the idea of long-term secular decline. Funnily enough, as we chatted, we also talked about another industry facing what I think are strong long-term secular trend driven headwinds, namely livestock farming. Both I think are in terminal decline but their ultimate, possible fates, are very different – and much depends on concepts such as marginal cost, capacity destruction and creative destruction.
Just as with the tobacco industry, we’re ultimately asking whether the energy business and more specifically the oil majors are a great value rebound story – or a secular degrowth story. I think the latter for the following reasons.
A great deal hinges on long term supply and demand dynamics. Leave for now the short term arguments over reflation. I think one can begin to sketch a bullish, contrarian narrative over the long term. In this telling, demand from emerging markets will continue to rise for at least the next decade as they modernise and industrialise and then turn into high energy consumer societies. We don’t need to rehearse these arguments but I would use one simple example – do we really think many Indians or African consumers will be racing to buy electric cars in the next two decades? My definitive answer to this is no. Demand will continue to increase from emerging markets although this doesn’t preclude counter vailing long term drivers towards say renewable energy. Its just that we’ll need lots of oil to power EM cars, planes, rucks and some industries (plastics).
The next leg of the bullish argument is that over the last few years we have seen a number of constraints on new sources of supply. The oil majors have massively cut back on capex spending and are also under intense moral pressure to scale back spending on new reserves. We have also seen some capacity destruction of existing reserves though I think this could easily be reversed. Crucially I suspect that the capital inflows into the low cost marginal US unconventional shale producers is now tapering off and will fall sharply as Wall Street reassesses this growth sector. I think that capex spending in the Permian for instance could roar back if prices stay above $60 but I think we won’t see anywhere near the same scale of spend across the broader US unconventionals sector.
Lastly, its clear that OPEC is demonstrating much greater supply discipline and has clearly signalled that it would like oil prices to stay nearer to $60 than $30. So, these all add up to a convincing case for oil to remain an important part of the energy mix, with the real possibility that prices could stay elevated above $60.
Now the bearish case. I think there is a fair chance that the US unconventional sector has subsided in importance and is no longer quite the marginal setter of price that it was. OPEC has achieved some of its objectives and is now a more powerful arbiter of the oil price than it used to be. But the headwinds facing the oil sector are real and structural. Any pathway to middle-class modernization for middle-income emerging markets probably has to involve a massive effort to replace oil with alternatives, initially natural gas and then renewables. China and other Southeast Asian countries are already on the pathway. Large bits of electricity generation and car transportation is slipping away from the hydrocarbon paradigm and will drive demand from the developed world ever lower. The race will be between declining developed world demand and increasing EM demand and my finger in the air guestimate is that by the mid-2030s the overall demand level will be declining.
Which then forces us to confront what I call the creative destruction dilemma. Back to my mention of livestock farming. My guess is that most mass-market, price-conscious producers of livestock meat will face intense headwinds by the mid-2030s as plant and other alternatives cut into mass-market products. This will force many farmers to make a crucial decision. Do they stick with traditional output or do they switch to alternatives? This is a difficult decision as they have sunk many tens of thousands of pounds into what will be legacy CAPEX which will need to be destroyed. But farms can do other things, and farmers can switch to alternatives. Governments will help by emphasizing ecological husbandry including carbon sequestration. And some farmers will switch to arable while others will stick with livestock but move upmarket, and produce premium products and stick with the huge pool of carnivorous consumers who like a prime steak from sustainable sources. In a simple way, creative destruction in Ag can be quick, and whilst not exactly painless, there are alternatives for some (though not all) farmers.
The long-term secular headwinds facing oil demand are more troubling. Declining demand might be helped in the medium term by some of the capacity destruction I have detailed. But eventually, the decline in demand outstrips that capacity destruction. Private oil businesses start to re-orientate their capital base and chase renewables. That will leave the market increasingly dominated by state-owned producers of oil, probably aligned to OPEC. Here we run into what I suppose we could call the problem of “incapacity destruction”.
Many nations and their oil champions have sunk countless hundreds of billions of dollars into huge hydrocarbon production infrastructures which they need to milk to pay for national welfare budgets. Unlike farmers who can engage in short to medium-term capacity destruction – helped by governments – these national oil majors must run legacy infrastructures that need to be paid for and used for many decades. This means that they’ll be forced to react to peaking and then declining demand the only way they can – increase supply. This will act as a long-term headwind for price (and margin) expansion.
My suspicion is that the big private sector energy behemoths probably already know this. Thus they are choosing one of two paths. The first – let’s call it the Shell/BP paradigm – is to switch to new forms of energy production using their cheap cost of capital. The second path – let’s call it the Exxon path – is to switch to a private equity model. Don’t worry so much about growth in the top line but focus on cost reduction and increase cash flow generation. Thus careful financial engineering might allow cash to outpace the decline in demand.
Back in the land of the nationalized oil majors, those two choices are not available. The first doesn’t really work unless someone can make carbon capture in declining oil fields really work at scale or you are the Saudi’s and you can build cities of solar in the desert.
The second route – to focus on cash flow – is fraught with danger as you confront powerful energy sector trade unions and other vested interests who will resist capacity destruction. Thus the simpler way out is NOT to destroy capacity and if anything squeeze every last barrel of oil out of your reserves. Thus incapacity destruction leads to a structural over-supply from nationalized energy majors. This comes to a market facing structural declines in consumer demand by the late 2030s and creates what I think will be a deadly combination. Oil prices will start to sharply decline by the late 2030s and the oil-based hydrocarbon economy doesn’t go out with a big bang – a price pop – but a whimper as oil prices begin to structurally slide below first $50 then $35. The Saudi’s, ever canny, will happily ride this train to nowhere as they diversify like crazy. But the rest of OPEC and the Russians are on a one-way journey to doom, which will, in turn, kick off major geopolitical trouble by the late 2030s as the nature of the decline becomes evident, especially to private sector providers of capital. As I have already outlined, long before say 2040, the large private sector operators will have worked out the name of the (end) game. Some majors will go private and become cash machines as they slowly die. But the great pools of capital will have moved on to pastures new.
So, in sum, the big oil companies really are dead in the water long term. Invest elsewhere!