The need for change
While oil prices have continued to rise in recent months, investment in new oil and gas projects have been stalled for some time. Investors are increasingly avoiding industries that produce fossil fuels and high CO2 emissions. This should sustainably support the price of a barrel of oil, but could also help to significantly accelerate the transition to renewable energies. An investment topic for the DJE - Dividende & Substanz.
By Stefan Breintner, Head of Research & Portfolio Management and Co-Fund Manager of DJE - Dividende & Substanz
We are currently experiencing a boom in the price of crude oil. Since the beginning of the year, the price of U.S. crude oil contracts has risen by more than 40%, while Brent crude, the more common North Sea brand in Europe, has increased by 35%. The large oil companies such as Exxon Mobil, Chevron, Royal Dutch Shell and Total Energies, which are currently generating record cash flows, are pleased that crude oil prices remain high or are rising.
Even before the start of the Covid pandemic the trend of declining investments in new oil projects was visible. This can be measured, among other things, by drilling activity. The U.S. Energy Information Administration (EIA) publishes monthly evaluations. These show that although drilling activity is increasing again, it remains below pre-Covid levels. In addition, the number of wells drilled but not fully completed continues to decline. So reserves at existing drilling projects are also declining.
However, high investment efforts in new production and drilling activities by the major energy companies have so far largely failed to materialize. This can be explained by the fact that energy companies also want to become "greener" and have therefore already started to diversify their product portfolios from fossil fuels to lower CO2 energy sources.
In addition companies from the sector have not had a good experience of making large investments in extraction activities within a short period. Between 2011 and 2014 they invested large sums in extraction projects, which did not pay off as desired. During this period production volumes rose faster than global demand, which ultimately led to a sideways trend in the oil price before it halved from 100 US dollars to 50 US dollars in 2014.
Fossil fuels are needed
The ESG trend also played a significant role in making the industry less attractive to many investors and investments were no longer made in oil projects due to stricter ESG guidelines. However, the sharp rise in oil prices in recent months also led to a rethink among many countries. Fossil fuels are still needed to sustainably manage the transition to renewable energies.
Furthermore, it is still reasonable to assume that the peak in global oil demand will not be reached until after 2030, assuming that investments in renewable energies continue to be strongly promoted and expanded. Until then further investment in the industry will be needed to meet global demand.
However to curb global demand the economic cycle could step in as a wild card. Over the last few weeks, there have been increasing signs that the growth momentum in the major economies is continuing to decline. Central banks are tightening monetary policy to a degree we have not seen since the 1970s in an effort to get inflation back under control. Nevertheless, if this tightening of monetary policy will now lead to a recession at the turn of 2023, demand for fossil fuels would again be drastically reduced. It would not be the first time that central banks have misjudged the fine line between monetary tightening and flattening economic growth and plunged the economy into recession.
Attractive dividend yields
Many US oil companies have taken advantage of rising crude oil prices and increasing profits to reduce their debt burden. This was also urgently needed as US oil companies in particular were heavily indebted and the brief oil price crash in March 2020 meant that the companies concerned were on the verge of insolvency. At present the debt reduction of the past two years is paying off even more as the refinancing of liabilities has become more expensive again in recent months due to rising capital market interest rates. In addition dividend yields on stocks from the sector are attractive and often exceed 4%. Given the fundamental situation, structural supply bottlenecks and the resulting high oil prices in the future, it seems realistic that these high dividends will continue to be paid in the future. Many companies are also still relying on extensive share buyback programs.
Currently, some companies, such as Chevron, Equinor or Total Energies, are actively buying back their own shares. With oil prices above $90 this should continue in the coming years.
Looking into the near future the major players in the market promise to slightly increase their investments again over the coming years, but in a much more diversified way than in previous years, such as 2011 to 2014, a time when investments in production projects reached their last peak.
Investment expectations of the oil industry
At the end of December 2021, 131 executives from the oil and gas sector were surveyed on their estimates for capital expenditures in their companies compared to 2021. 78% of the executives surveyed expect a slight or significant increase in capital expenditures this year compared to 2021. It should be emphasized that the statistics only refer to U.S. companies from the production sector (upstream), i.e. precisely those market participants that are ultimately in a position to increase production in the short term.
The next few months will show whether the announced investments in new drilling projects will actually be put into practice and whether these efforts will be sufficient to adequately meet global demand. However, investment house Goldman Sachs currently believes that we will see a big difference from past investment cycles in the fossil fuel industry.
Whereas in past investment cycles we've seen investment double in two or three years when energy prices are at such a high level, this time we'll probably see a maximum increase in investment of 20 to 30% over the next two to three years. Consequently the structural conditions are starting to make themselves noticeable. This is where the dilemma of the oil companies becomes visible: Investments in renewable energies or more CO2-friendly technologies are by far not as profitable as investments in the classic oil/gas business, but there is no way around it in order to comply with climate targets.
ESG accelerates change
This means the energy industry is also evolving and oil companies are making their CAPEX spending more sustainable. Total Energies, for example, plans to allocate 25-50% of its investment budget to renewables and low-carbon energy production over the next four years, Royal Dutch Shell plans to allocate half of its investment budget to the same area by 2025 and British energy company BP is setting the same goal by 2030. In general U.S. companies lag massively behind European companies in investing in renewable technologies. High-energy prices can help accelerate the transition to a more CO2-neutral society. True to the motto: the more expensive fossil fuels are the cheaper renewable and more CO2-friendly alternatives become in relation.
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