Oil is the new tobacco

04/07/2022

Oil and gas are not sustainable and therefore an investment taboo. Except for the private investors who are milking the cow now that energy prices are peaking. This is at the expense of sustainable investors who sacrifice returns for it, while polluting energy continues to grow in the shadows.

The Russian war on Ukraine is a painful reality check for sustainable investing. Under the banner of ESG - Environment, Social, Governance - fund managers have been able to attract investors' money in recent years. Their promise: a better planet, with respect for the environment, people and good governance. Avoiding listed companies that sin against ESG would not cost investors any returns, on the contrary. Doing good and earning more from it, that was the irresistible pitch. However, Russian President Vladimir Putin's brash war against Ukraine is shaking the ESG building. Many sustainable funds turned out to have leading Russian companies that are now being denounced. That was a wrong moral assessment that also cost sustainable investors a handful of money due to the price implosion of companies such as Sberbank, Severstal and Lukoil. Before the invasion, they were among the top 25 percent in their sector, according to a leading sustainability ranking.

The essence

The shares of oil and gas companies excel on the stock exchange thanks to the high energy prices. In the near future, their cash flows will increase as those companies invest less and less in new resources.

What does that mean for sustainable investors?

The return on sustainable investments has recently come under pressure, partly because fossil energy is avoided.

Who benefits?

Hedge funds, private equity players and some sovereign wealth funds are buying up the oil and gas businesses that asset managers and energy companies are dumping under pressure from ESG.

In addition, the war has sharpened the issue of fossil fuels and the energy transition. Oil and gas prices had already risen sharply last year due to the great energy hunger in the wake of the pandemic. The war has now added to supply uncertainty, with a geopolitical imperative to reduce Western energy dependence on aggressive regimes such as Russia's. It creates a perfect storm in the energy market at a time when sustainable alternatives are far from sufficient to meet our energy needs.

World upside down

For sustainable investors, the world suddenly seems to be turned upside down. Weapons have always been taboo, but some are now arguing that they are necessary to defend democracies from despots. Viewed in this way, weapons could still be sustainable. Pumping up American oil and gas should shield the West from the Russian energy weapon and temper exploded energy prices. It leads to a bizarre situation in which the Biden administration appeals to the patriotism of the US oil industry to pump more, while the White House adopts an ambitious agenda to wean off fossil fuels.

Stock markets are also being turned upside down. After years of malaise, the denounced energy stocks are suddenly the big winner on the stock market. The Stoxx Europe 600 index has lost 6.5 percent since the beginning of the year, while European energy companies within that group of 600 leading stocks were up more than 16 percent over the same period, with a 32 percent gain for Shell. In the US, the picture is more pronounced: a loss of about 5 percent for the S&P 500, compared to gains of 35 to 40 percent for players in the oil and gas industry.

At the same time, sustainable funds are suddenly under pressure. In January, the top ten sustainable funds lost 9.2 percent of their value. That loss was almost double what the world stock markets lost in the same period. The disappointing stock market performance threatens to be accompanied by an outflow of investor money. The Bernstein stock exchange signalled that in the first week of March there was a rare net outflow from ESG funds, good for 1.3 billion dollars. The "love affair with ESG" has been put on the back burner for a while.

There are two main culprits for the recent underperformance of sustainable funds. The first is the sharp rise in oil and gas prices, which are generating huge profits for energy companies. For example, US energy giants Exxon-Mobil and Chevron recorded a combined profit of $38.6 billion last year, their largest annual profit since 2014. Exxon will use $10 billion of that profit to buy back its own shares over the next 12 to 24 months. . That should give the price an extra boost. Because ESG funds are fossil Avoiding energy misses that bonanza for sustainable investors. All the more so as energy stocks typically thrive during periods of high inflation, such as today.

In addition, rising interest rates - in the wake of the inflation surge - are playing tricks on sustainable investors. ESG critics have long pointed out that sustainable funds owe their alleged superior performance in recent years to a large extent to the phenomenal rally in tech stocks, which are said to be sustainable. Tech stocks are growth stocks, companies that have to realize a significant part of their growing profits in the future. At higher interest rates, all that future profit is worth less today, which puts pressure on valuations. The same applies to the green energy companies in which ESG funds have invested enthusiastically in recent years. It undermines the adage that sustainable investors do not have to sacrifice returns and may even outperform. In a world of expensive oil and rising interest rates, this does not seem to be the case at all.

Tipping moment

In 2020, we at expatwealthatwork have decided to exclude fossil energy from our sustainable funds, without being blind to energy needs. It's about taking the bump with the bump. Our final verdict was negative for fossil energy.The question is whether that sector is capable of reinventing itself, and on what scale it can do that. It is inevitable that capital will be destroyed in those companies, for example by leaving oil reserves in the ground. and will there be sufficient replacement in the form of new activities? If you look at that balance sheet, we believe the oil and gas sector will destroy more value than it creates in the long run.

The oil sector can still benefit from expanding cash flows. Opportunistic investors like to milk that cow.vIn the short term, there is a tendency to overestimate the decline in demand, while we underestimate it in the long term. In other words, the hunger for fossil fuels will remain high for the foreseeable future. It will turn energy companies into cash cows, especially at today's high oil and gas prices. Cash creation is boosted by the fact that oil and gas companies can afford to invest less in developing new wells. They are doomed anyway, and the death throes will accelerate if current tensions accelerate the energy transition.

We draw a parallel with the tobacco companies, which in the first phase went into an extremely lucrative period after the denunciation by consumers and governments. They were able to compensate for the slowly declining demand through higher prices and higher margins. Also because the substantial advertising expenditures fell away after they were banned. The result is cash flows swelling until a tipping point is reached and there is no alternative to destroyed demand. But until then, opportunistic investors will be happy to milk the cash cow.

The same is gradually happening with producers and distributors of fossil energy. One way to exploit this is to pay out massive amounts of cash, through dividends or buying back own shares. That process is already underway, as evidenced by the plans of ExxonMobil, among others.

A radical shift is noticeable under pressure from professional investors, especially among American shale oil producers. Shale oil has long been considered the ultimate exponent of the booms and busts that characterise the energy sector. A rising oil price typically unleashed a rush for new resources, only to leave a hangover when the oil price plummeted again. Discipline has prevailed since the painful oil crash in the spring of 2020. Profit exceeds extra pumped volumes. To the extent that the CEO of Pioneer Natural Resources, a major shale oil producer, recently said his shareholders will not allow him to produce any more. Not even at an oil price of $120 a barrel. The White House is undoubtedly looking at it with sorrow.

Divest

But who is milking the cows if they are not the sustainable investors? This is especially apparent from private investors, such as hedge funds, private equity players and sovereign wealth funds. They are less in the spotlight than the large asset managers who, under pressure from clients such as pension funds and foundations, apply an ESG screening to their portfolios. It obliges asset managers to divest their investments in fossil energy.

The same goes for large energy companies such as Shell, which are selling their most polluting activities in order to please shareholders. The selling pressure usually means that a discount card hangs on everything that has to do with oil, gas and coal.

The private investors accept the gift with a broad grin. They leave fantastic returns on the table. The ESG reflex is short-sighted, because it denies energy companies the means to make the energy transition possible.

Private equity players, who use debt leverage for their investments, are also enthusiastically shopping in the oil and gas bazaar. Over the past two years, private equity has bought $60 billion in oil, gas and coal activities. That is a third more than the amount it invested in renewable energy. Finally, some sovereign wealth funds and private oil groups such as Saudi Aramco are also willing to buy up the banned activities.

The bottom line is that ESG's central double promise - earning good by doing good - is in danger of becoming an empty box. Sustainable investors are sacrificing returns and it makes no difference to the planet as long as sufficient alternative capital is available for fossil energy. The idea that the massive denial of investor money would make capital more expensive for undesirable activities - and therefore less lucrative - does not hold true here.

What's more, polluting activities disappear into the shadows, where there is less pressure to make a well-considered transition to a low-carbon society. Under the spotlight of the stock market, flat opportunism and muddling through is harder to sustain. When a private equity player steps into the capital of an oil company, you have a different logic. Then there is often no more room for green projects. In most cases, it's about earning maximum money.

If you know your current banker, broker or advisor isn't acting in your best interests, or your investments are performing as they should or worse, you aren't sure, tackle it head on! Sacrifice brings desired results quicker. Contact us today for a No Obligation X-Ray Portfolio Review: info@expatwealthatwork.com