Year: 2022

The energy crisis that has hit Europe with runaway gas and electricity prices following the Russian invasion of Ukraine shows just how dependent on fossil fuels we still are. Even though Europe is at the forefront of the renewable energy expansion, we still get 71 percent of our energy from fossil fuels. At the beginning of the year, Europe imported 40 percent of its natural gas and 30 percent of its oil from Russia. Now that Russia is using gas as a geopolitical weapon, energy security has emerged as a catalyst to speed up the energy transition.

Via its Repower EU investment plan, the EU intends to phase out Russian oil and gas as rapidly as possible (by 2030 at the latest) and accelerate the pace of investment in renewable energy sources and energy savings. In an interesting turn, the EU Taxonomy now classifies nuclear energy and natural gas – from sources other than Russia – as sustainable during a transition period (to 2045 for nuclear and 2030 for gas). The energy transition is essential to attaining environmental and climate goals, but this takes time and the existing energy system cannot be dismantled before the new one is up and running. The investments that must be made are energy-intensive in and of themselves. Nuclear power is needed in the new system, as well as oil and gas during an extended switch-over period. If we stop investing in these energy sources while the global demand for energy continues to grow as forecast, there is risk that the current situation in Europe (with costly energy and high inflation) will become the new normal.

In the choice among fossil fuels, the largest possible coal component should be replaced by natural gas

The energy transition is the greatest challenge of our time, but also provides several interesting opportunities from an investment perspective. A lot of people associate the theme with solar, wind power and electric cars, but several other interesting verticals are driven by the same underlying trend. In previous reports, we have addressed areas such as batteries, ‘green’ metals, sustainable agriculture and smart materials. The valuations related to these aspects of the transition, which are at least equally important, are in many cases more attractive than the most obvious winners in the theme.

The conventional energy sector is another potential, perhaps a bit unexpected, winner. There is risk that the transition will be a period of structurally higher oil prices driven by limited capital investments. However, this combination does entail increased free cash flows that can be returned to energy company shareholders even as valuations remain low. We therefore believe that selected parts of the conventional energy sector also have a place in a wider portfolio within the energy transition and energy security theme.

Components of energy transition
Supply: Phasing out oil is a long-term proposition. Fossil fuels cannot be shut down overnight. According to current forecasts, demand for oil will not peak until 2030, after which it will slowly fall back to just below current levels by 2050. But not all fossil fuels are equally harmful to people and the climate – from this perspective, coal is worst by far. In the choice among fossil fuels, the largest possible coal component should be replaced by natural gas. A significant share of oil consumption comes from transportation. An electrified vehicle fleet can make a difference here to reduce demand.

Solar and wind power are going to grow further in the future. Costs have fallen dramatically in the last 10 years, which makes the switch from fossil fuels economical even without subsidies. Nevertheless, solar and wind cannot support a functioning energy system on their own, power provision has to be weather-independent, plannable base power. Right now, fossil fuels, nuclear power and stored hydropower serve that purpose. Gas and hydropower constitute regulating power that can be rapidly switched on and is dependent upon demand. In a new system, large elements of which are renewable, the hope is that energy storage – via batteries, hydrogen gas or hydropower (pumped storage) – will replace fossil fuels as base power. At present, storage capacity is unfortunately insufficient and relatively expensive. This is another reason why nuclear power is likely to play an important role in the new system as well.

Demand: Underinvestment. The energy transition is also happening on the demand side. Global demand for energy actually declined during the lockdowns in 2020, but we are on the way back to the earlier growth rate. Given the limited investments in fossil fuels in the last 10 years, there is risk that supply will not suffice to meet demand. This could result in a protracted period of high energy prices. The advantage to higher prices is that they increase incentives to save energy. As we illustrated in earlier theme articles, more efficient building materials and heating systems, smarter and lighter materials in industry and recycling can drastically lower consumption.

A diversified energy portfolio
The energy transition is a wide theme with numerous structural impetuses. Accordingly, an energy portfolio should contain a wide spectrum of exposures to renewable energy as well as selected segments of conventional energy. Such a universe would also include companies that are benefiting from increased electrification, have exposure to ‘green’ metals, or are in the business of improving energy efficiency.

Renewable energy and electrification: Most of us associate the energy transition with solar and wind energy, electric cars, batteries, biofuels and expansion of the electricity network. This is where we find the obvious beneficiaries of green initiatives, in companies that are often traded at fairly high valuation multiples. But interestingly, suppliers that are benefiting from the same trends but have more attractive valuations can be found a bit further down the value chain. Considering the strong structural tailwinds, the portfolio should have a strategic overweight against this segment. There are large differences in profitability and valuation among the companies, so selectivity is key.

There is huge potential for improvement in industry through process optimisation, smarter materials and more energy-efficient systems

Conventional energy: Demand for fossil fuels is expected to continue rising, but the current high oil price has not yet resulted in increased capital investments in line with the historical pattern. The problem is that long-term projects are associated with greater uncertainty than ever. Regardless of the forecasts, there is actually no way of knowing how rapidly the transition will proceed or what the political landscape will look like in the future. Numerous institutional investors have completely excluded conventional energy from their portfolios in response to new ESG mandates.

Remaining shareholders and private equity have instead prioritised better earnings and cash flows. Willingness to initiate risky projects may increase if the oil price remains high for a long time, but lead-times are long. We may therefore be facing a protracted period of structurally higher oil prices than we have had in the last decade.

Very little of this is reflected in company valuations. In spite of strong performance so far this year, the energy sector is still being traded well under the historical average relative to the market. Analysts are using fairly conservative estimates for the long-term oil price in their models, at about $60–70 per barrel, which is far below current levels (and even further from the upside scenario, where the oil price parks at above $100 per barrel for an extended period).

Alongside this, companies are generating high free cash flows that will (provided that they are not invested in new projects) be distributed to shareholders or used for share buybacks. Considering the uncertain future, these companies will probably have a higher risk premium than they have had in the past, but much of this is already priced in. In view of the large profits, there is no need for multiple expansion to recoup the investment.

Naturally, a recession that depresses short-term demand, high taxes and company-specific risks must also be considered. But this is supported by the valuation and we thus still recommend a tactical overweight in the conventional energy sector. For the longer term, we recommend greater selectivity, with exposure to the segments that will be needed during a long transition period. This applies to oil companies to an extent, but companies in natural gas and liquefied natural gas (LNG) above all. If Europe is serious about eliminating dependency on Russian gas, large volumes of natural gas will have to be imported from other sources, primarily in the form of LNG from the US. Increased production and a large-scale expansion of the LNG infrastructure, with new terminals, freight options, etc, will be required to meet higher demand for LNG. We avoid coal, oil sand and the most environmentally harmful segments of the conventional energy sector in our theme portfolio.

Tactical investments in a wide energy-sector ETF are a short-term option. For the long term, we recommend an active manager who takes selective exposure against the segments of the sector that are benefiting from the energy transition, and excludes coal and oil.

Nuclear: Nuclear power produces minimal carbon emissions, is a base power in the energy system and could replace coal power without significant difficulty. One problem has been the negative public opinion following the Fukushima disaster, as well as high costs. There have been recent signs of a turnaround not only in the US and parts of Europe but also in Japan, which is beginning to restart reactors. It is hoped that technical progress will soon make Small Modular Reactors (SMR) cost-competitive.

Opportunities to invest directly in nuclear power technology are unfortunately limited (most companies are unlisted). The remaining alternative is exposure via uranium, the fuel currently used in nuclear reactors. There are companies whose business model is to keep uranium in stock, and these provide indirect exposure to the uranium price, as do mining companies that extract uranium. After many years of low prices, however, few of the latter are profitable and risk in the sector is high. Factors indicating a higher uranium price are that few investments have been made in the last 10 years (post-Fukushima) and that lead-times for new projects are relatively long. If demand takes off, driven by new nuclear power expansion, a large uranium shortage could develop. Considering that uranium accounts for a marginal fraction of the operating costs of a nuclear power plant, the price could rise quite significantly without affecting demand. The potential upside is large but volatility is high and there is always a risk that public opinion will shift and become more negative if a new and serious accident occurs.

Energy efficiency: Reduced demand for energy is the other key part of the equation for attaining climate goals. As we explained before, energy consumption can be lowered by relatively simple means: better heating systems, optimised electricity consumption in buildings and more efficient building materials. There is huge potential for improvement in industry through process optimisation, smarter materials and more energy-efficient systems. Carbon disclosure and a higher price for CO2 (via emissions allowances) are accelerating factors here. Materials recycling is another important area.

Energy efficiency improvements have climbed higher on the agenda in the last year. The area plays a key role in the environmental programmes Repower EU and the US Inflation Reduction Act. Although Europe’s costly electricity is an obvious catalyst that is increasing the need for energy efficiency improvements, sales for many companies that are contributing energy efficiency solutions are linked to the general building cycle. Short-term economic anxiety has to an extent cast the long-term structural growth case in the shade. This is reflected in the valuations, which are starting to look attractive for several companies within the theme. As a result, we see an interesting position in which to increase this exposure going forward.

Portfolio mix: Growth and value
The combination of the above components produces a diversified energy portfolio where the transition is the underlying driver. Certain segments – such as renewable energy, electrification and batteries – stand out as growth investments that are benefiting from the huge investments that will be required for decades to attain climate goals. Valuations are higher here and profits are further away in the future. The situation is the opposite within conventional energy. The bulk of the profits is expected to be made in the near term and valuations are low. Reluctance to invest in the conventional sector has lowered company valuations across the entire value chain, even though we can expect continued growth in demand for some segments of the oil and gas sector over a long transition period. The ‘green’ metals are natural resources that we must use to an increasing extent in the new system, while it is hoped we can slow the growth rate on the demand side by means of energy efficiency improvements.