The Dicey Economics of Investing in Oil During Covid-19 – The Wall Street Journal

Does investing in oil and gas companies still make sense? Money manager Jacinto Hernandez has doubts.

The partner at Capital Group Cos. liquidated $1 billion in oil and gas stocks as Covid-19 spread around the globe in February, according to regulatory filings. Mr. Hernandez said he suspected the new coronavirus was about to crush global demand for gasoline, diesel and jet fuel—and with it, any near-term thesis for investing in oil companies.

Adam Waterous, a Canadian private-equity investor, looked at the same circumstances and came to the opposite conclusion: This was the time to buy. Demand will eventually bounce back, he said, and when it does, prices will spike sometime later this decade. He backed up that conviction in July when his Waterous Energy Fund purchased a big stake in an oil sands company.

“There is absolutely a stigma about investing in oil and gas,” Mr. Waterous said. “It hasn’t been a sexy industry for a while.”

The question of whether to invest in oil and gas has become a polarizing issue in the world of money management. Even before the pandemic sapped the world’s thirst for fuel, the future of the fossil-fuel industry was already under threat due to the rise of electric cars, the proliferation of renewable energy and growing consciousness about the long-term impact of climate change.

Adam Waterous, managing partner and chief executive of Waterous Energy Fund, concluded during the pandemic it was time to invest in oil. He is pictured here at his office in Calgary.

Photo: Allison Seto for The Wall Street Journal

The biggest oil companies increasingly disagree on what the future holds. Exxon Mobil Corp. continues to invest in increasing oil production and has said it believes oil demand will increase for years to come. BP PLC, by contrast, believes demand may already have peaked and plans to reduce its oil and gas production by 40% over the next decade as it pivots to green energy.

What makes the situation even more challenging for investors are new questions about the direction of oil prices, which no longer follow the fairly predictable cycle of boom and bust that governed the industry for much of the past century. Prices traditionally fell when supply exceeded demand, and rose when reduced investment in new drilling resulted in shortages. In the past decade, America’s widespread adoption of hydraulic fracturing disrupted that historic pattern, resulting in a flood of new oil that could be produced quickly. That tamped down price spikes and eroded profits.

Brent oil, the global benchmark, last topped $100 a barrel six years ago. This April, the pandemic briefly led U.S. oil prices to fall into negative territory for the first time ever. So much oil backed up in storage that investors literally paid people to take it off their hands. When prices recovered, oil companies didn’t benefit as they might have in the past. Since the end of April, U.S. oil prices have more than doubled but a stock index of U.S producers is up only about 21%. Brent crude prices topped $50 a barrel Thursday for the first time since early March, part of a broad market rally fueled by investors’ anticipation for a 2021 economic resurgence.

The quandary investors now face is this: Will global oil demand recover before EVs, renewable power, and environmental regulations permanently dent the market for fossil fuels?

Reduced ambitions

There are signs that demand may not recover permanently. The International Energy Agency expects that global oil demand will peak sometime in the 2030s even as the world churns through around 90 to 100 million barrels of oil a day for the next two decades. Next year, capital expenditures in renewable power supply are expected to overtake oil and gas for the first time in history, according to Goldman Sachs Group Inc.

Investors are one of the main forces driving this transformation, according to Goldman. Climate change-related shareholder resolutions have nearly doubled since 2011, the bank said, with the largest share of them, about 30%, directed at oil and gas companies. This fall Exxon temporarily lost its crown as America’s most valuable energy company to NextEra Energy Inc. —a Florida utility that has become a green giant with aggressive wind and solar farm investments.

Shaky Recent Past

Oil stocks have typically moved in tandem with oil prices, creating boom and bust cycles. Both are down from a decade ago, and more recently the main index of U.S. oil producers has significantly trailed oil price gains.

Crude-oil close price vs. stock index of U.S. oil producers*

Change from Dec. 10, 2010, monthly

June 30, 2014

Stock index outperformed oil price

Oil price: +18%

Stock index: +63%

Stock index

outperformed

oil price

Stock index

underperformed

oil Price

stock index

Dec. 10, 2010

Dec. 9, 2020

Stock index underperformed oil price

Oil price: -49%

Stock index: -70%

Major oil companies’ performance has plummeted over the past decade, as producers have struggled to be profitable in an era of abundant oil.

Quarterly return on equity, through 3Q 2020†

Exxon

1.6%

Chevron

-8%

Shell

-9.3%

Crude-oil close price vs. stock index of U.S. oil producers*

Change from Dec. 10, 2010, monthly

June 30, 2014

Stock index outperformed oil price

Oil price: +18%

Stock index: +63%

Stock index

outperformed

oil price

Stock index

underperformed

oil Price

stock index

Dec. 10, 2010

Dec. 9, 2020

Stock index underperformed oil price

Oil price: -49%

Stock index: -70%

Major oil companies’ performance has plummeted over the past decade, as producers have struggled to be profitable in an era of abundant oil.

Quarterly return on equity, through 3Q 2020†

Exxon

1.6%

Chevron

-8%

Shell

-9.3%

Crude-oil close price vs. stock index of U.S. oil producers*

Change from Dec. 10, 2010, monthly

Stock index

outperformed

oil price

June 30, 2014

Stock index outperformed oil price

Oil price: +18%

Stock index: +63%

Stock index

underperformed

oil Price

stock index

Dec. 10, 2010

Dec. 9, 2020

Stock index underperformed oil price

Oil price: -49%

Stock index: -70%

Major oil companies’ performance has plummeted over the past decade, as producers have struggled to be profitable in an era of abundant oil.

Quarterly return on equity, through 3Q 2020†

Exxon

1.6%

Chevron

-8%

Shell

-9.3%

Crude-oil close price vs. stock index

of U.S. oil producers*

Change from Dec. 10, 2010, monthly

Stock index

outperformed

oil price

stock index

Stock index

underperformed

oil Price

Dec. 10, 2010

June 30, 2014

Stock index outperformed oil price

Oil price: +18%

Stock index: +63%

Dec. 9, 2020

Stock index underperformed oil price

Oil price: -49%

Stock index: -70%

Major oil companies’ performance has plummeted over the past decade, as producers have struggled to be profitable in an era of abundant oil.

Quarterly return on equity, through 3Q 2020†

Exxon

1.6%

Chevron

-8%

Shell

-9.3%

The challenge facing traditional oil and gas companies is how to make money as the industry changes. The minimum rate of return required to finance long-term oil projects has increased to as much as 20%, according to Goldman, compared with as little as 3% for renewable projects. The squeeze on capital has led to a dramatic pullback in spending. This month, both Exxon and Chevron Corp. sharply reduced their capital expenditure plans by billions of dollars a year through 2025.

Even if oil prices go up due to a decrease in oil and gas supply, as analysts predict, companies are unlikely to sign off on new mega projects due to long-term fears about energy demand. Raymond James estimates oil project investment will never fully recover to pre-virus levels.

Two sides of the same coin

Some investors aren’t waiting around to find out how things turn out. Those who are paid to mirror the broader market have all but abandoned the industry due to changes in the composition of the S&P 500. Energy stocks have fallen to less than 3% of the S&P 500 and Exxon was dropped from the Dow Jones Industrial Average in August.

For investors who still have an appetite to own Western oil companies, two divergent corporate options are emerging. The first, pursued mostly by U.S. oil companies, is premised on sustained, though relatively reduced, investment in oil and gas production to capture an uptick in commodity prices later this decade. Exxon and Chevron primarily aim to address climate change by reducing the carbon intensity of fossil fuels, through technologies like carbon capture. Both say maintaining their dividend is a priority.

“[W]e conclude that the needs of society will drive more energy use in the years ahead—and an ongoing need for the products we produce,” Exxon Chief Executive Darren Woods wrote in a note to employees in October.

The second option, predominantly pursued by European oil companies, involves a dramatic corporate shift to investing in renewable energy, based, in part, on a belief that oil demand may plateau sooner than expected. BP and Royal Dutch Shell PLC have pledged to reach net-zero carbon emissions, using oil proceeds to fund billions of dollars of investment in renewable energy. Both have cut their dividends to free up cash. BP plans to shrink its fossil fuel production over time.

Uncertain Future

Many analysts now predict that oil demand will peak in the 2030s, and that the global pandemic may have permanently erased millions of barrels a day worth of demand. A rapid move to renewables and fossil fuel regulation could further dent demand.

World oil demand and projections

Projections based

on outlook in:

 million barrels a day

2019, base case*

Projections

2020, base case*

2020, alternative scenario†

The value of many producers’ oil and gas reserves fell during the 2015 oil price crash, but haven’t fully recovered despite stronger prices.

Proven reserves value

Exxon

$89.9 B

Chevron

$100.5 B

BP

$96.6 B

Shell

$77.7 B

Projections based

on outlook in:

 million barrels a day

2019, base case*

Projections

2020, base case*

2020, alternative

scenario†

The value of many producers’ oil and gas reserves fell during the 2015 oil price crash, but haven’t fully recovered despite stronger prices.

Proven reserves value

Exxon

$89.9 B

Chevron

$100.5 B

BP

$96.6 B

Shell

$77.7 B

Projections based

on outlook in:

 million barrels a day

2019, base case*

Projections

2020, base case*

2020, alternative

scenario†

The value of many producers’ oil and gas reserves fell during the 2015 oil price crash, but haven’t fully recovered despite stronger prices.

Proven reserves value

Exxon

$89.9 B

Chevron

$100.5 B

BP

$96.6 B

Shell

$77.7 B

Projections based

on outlook in:

 million barrels a day

Projections

2019, base case*

2020, base case*

2020, alternative

scenario†

The value of many producers’ oil and gas reserves fell during the 2015 oil price crash, but haven’t fully recovered despite stronger prices.

Proven reserves value

Exxon

$89.9 B

Chevron

$100.5 B

BP

$96.6 B

Shell

$77.7 B

“The more we understand about the impact of Covid–19…the more convinced we are that the path we have chosen and the destination we have set are the right ones for BP,” BP Chief Executive Bernard Looney said in a note to employees in August. “And we intend to move quickly —within a decade, we expect to be a very different kind of energy company.”

So far, neither strategy is popular. Since May, Exxon’s shares are roughly flat, and BP’s are down about 5%. No oil-and-gas company has figured out how to make money in a low carbon-energy world, according to Peter Bryant, a managing partner at business consultant Clareo.

“Exxon and BP are two sides of the same coin,” Mr. Bryant said. “Investors don’t like either.”

While many investors support green investment, they are unconvinced major oil companies can make the new business profitable. According to a Boston Consulting Group survey of 150 investors, 86% believe clean energy investments could help oil-and-gas companies, but only 25% of them said oil and gas stocks will become a larger part of their portfolio in the next decade.

An abundance of fossil fuels combined with advances in technology to harness wind and solar power has sent energy prices crashing around the world. WSJ explains how it all happened at once. Photo illustration: Carlos Waters/WSJ (Originally Published July 21, 2020)

A five-alarm fire

One activist investor, Jeff Ubben of Inclusive Capital Partners, is buying the European transition story. He invested $75 million in BP in March and set a five-year goal to make money from the investment.

He is currently raising more for his fund. “If I am successful in raising the money I will put $1 billion into a big oil company,” said Mr. Ubben.

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Mr. Ubben said he believes major oil companies should have excess cash to spend on clean energy by cutting costs, spending and dividends. The firm bought BP shares after 50-year-old Mr. Looney became chief executive in February and said the British conglomerate would reduce its dependence on oil.

Mr. Ubben’s firm has made several other low-carbon energy and technology investments, including electric-truck startup Nikola Corp. and electricity producer AES Corp. While he said he doesn’t believe the virus will accelerate the clean energy transition, Mr. Ubben does think it will increase divestment from oil and gas companies. To counteract that, he said the companies should use their cash flows to transform the business instead of increasing dividends or buying back stock.

Why would you return money to shareholders, he said, “if you want to be an energy company of the future?”

Not all investors share this view. After Shell cut its dividend for the first time since World War II in April, the asset management division of Virginia-based broker-dealer Davenport & Company LLC sold its position in the oil giant.

“We thought they could continue paying that dividend so that just took us a bit by surprise,” said Bradford Seagraves, research analyst at Davenport. “The income component was certainly an important consideration for us.”

Shell increased its dividend by a small amount in October after cutting it by two-thirds, telling investors it could cover both the payout and its investments in renewable energy.

The high dividend yields of Chevron and Exxon are attractive especially to individual investors who may rely on the payouts as a source of income, said Noah Barrett, an analyst at Janus Henderson Investors.

But the companies have to be able to cover the dividends from their cash flows for them to be sustainable, said Mr. Barrett. Exxon has had to borrow to cover its dividend this year, which costs it about $15 billion annually. Chevron hasn’t had to take on substantial amounts of debt during the pandemic or borrow to cover its dividend.

“If I’m a retail investor I still care about the share price,” Mr. Barrett said, who works for a Janus fund that owns Chevron shares. “The monthly check is nice, but the value of my holding is still going down.”

The industry will need to return cash to investors quickly to convince them to shrug off long-term concerns about the value of their holdings, said Capital’s Mr. Hernandez, the money manager who sold $1 billion in oil and gas stocks earlier this year. “We don’t really know what the demand is going to be” for years to come, Mr. Hernandez said.

Those warnings don’t faze Mr. Waterous, who previously headed investment banking at the Bank of Nova Scotia before founding Waterous Energy Fund in 2017. He said he believes investor disaffection with the industry is divorced from its supply and demand fundamentals, and that is why he pounced this spring after prices turned negative.

Within days, his team had put out proposals to acquisition targets. His fund purchased 45% of oil sands company Osum Production for about $111 million—one of the few private equity oil deals thus far in 2020. In November, the fund launched a takeover bid to buy an additional 40% of Osum’s shares for about $99 million.

“It became a five-alarm fire,” he said.”It became ‘oh my God, we’ve got to do this right away.’”

Write to Christopher M. Matthews at christopher.matthews@wsj.com and Sarah McFarlane at sarah.mcfarlane@wsj.com

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