Energy in focus

Read this article to understand:

• The drivers of the recent spike in energy prices
• How net-zero targets are changing the geography of fossil-fuel production
• The risk and governance implications of the energy transition

Ripples from the conflict between Russia and Ukraine and various international intermediaries are being felt in the energy market. While the conflict will clearly be the main market driver in the near term, there are other structural forces at play that are likely to have a material impact on the long-term future of the industry.

Although the energy sector has trailed broader equity indices over the last decade (Figure 1 shows sector performance relative to MSCI World), the price of gas had jumped before the incursion (Figure 2). It has been in demand as one of the less-polluting fossil fuels expected to play a bridging role in the transition.

Figure 1: Equity energy sector returns have lagged broader indices - MSCI World versus MSCI World Energy

Source: MSCI, February 28, 2022¹

Figure 2: European natural gas prices have surged (Dutch TTF (EUR), 2012-2022)

Source: Trading Economics. Data as of March 7, 2022²

But there have been other factors at play. An exceptionally cold spell in Asia, disappointing output from renewables like wind, outages at French nuclear reactors, and surging global demand have all played a part. Demand for petroleum and liquid fuels has been buoyant coming out of the COVID-19 pandemic and while supply has returned, it has failed to recover to pre-COVID levels. The result has been a surge in nearly all commodities, most recently supercharged by the Ukraine-Russia crisis.

So, how could this impact the energy transition? And where will it end? In the first of a two-part Q&A, we ask experts from our credit, equities and ESG teams for their thoughts: Derek Foster, senior credit analyst (DF); Chris Murphy, equity income portfolio manager (CM); Rick Stathers, senior ESG analyst and climate lead (RS); and Lei Wang, senior credit analyst (LW).

Talk us through the complex factors driving the energy price spike

LW: This is a rapidly evolving situation. Europe is highly dependent on natural gas from Russia, which provides about one third of all European supply (see Figure 3 for energy vulnerability). Other European producers have been cutting production; there has been limited investment for years and we have seen gas production collapse in the North Sea, for example.

Figure 3: European energy vulnerability (2019)

Note: Index based on share of fossil fuels in gross available energy, energy imports dependency, share of Russia and Ukraine in oil and petroleum imports, and share of Russia and Ukraine in natural gas imports.
Source: BCA, March 3, 2022³

But the state of the market reflects many other factors as well. China, Japan, and Indonesia are also experiencing energy shortages because China has begun the energy transition. China has been looking to buy LNG ahead of the Europeans and it is willing to pay higher prices. That's contributed to the tight market and why we are collectively paying a higher price for fuel. There is another factor to consider too. With the cost of LNG so elevated, China recently made the strategic decision to increase coal production to combat the extremely high price.

The stringency of the sanctions imposed on Russia have exacerbated the supply situation. Majors like BP and Shell are committed to exit. ENI is going to step back from its joint venture with Gazprom, and Total is planning to stop new capital investment in Russia as well. It is almost impossible to find buyers for these assets at the moment. The crisis is worsening.

DF: This spike has been a long time in the making, driven by decisions made by countries, industries, companies and regulators, in Europe and other parts of the world. The situation was supercharged by the COVID-19 recovery, and now we have the Ukraine-Russia crisis as well. Prices have spiked to levels we never dreamt they could, which just shows how fragile and delicate the energy transition is going to be.

CM: There are a lot of things happening, and it is impossible to ignore the important geopolitical issue around why Western Europe has become so reliant on Russian gas.

Although we know hydrocarbons need to be taxed and prices need to be higher to incentivise alternatives, that is going to prove extremely painful in the short term. Ultimately, though, higher prices are a positive for the planet. We have been in an era of low inflation and low interest rates for decades, but if we want the world to change quickly, we must face hydrocarbon inflation and acknowledge the effects on the consumer.

The big question is: who benefits from this phase? Should it be the old, established energy companies? My argument is that it should not. Either these companies should be investing in windfarms, battery storage and greener assets, or capital should be given back to shareholders.

Oil companies have known about global warming for decades and been in denial. They have been dragging themselves slowly into this new environment, due to the way in which incentives have been designed. If a chief executive expects a tenure of three to five years, perhaps ten at most, they want to be on the record as having been successful. Although metrics are changing, they have historically focused on the share price and total return, and those factors would not have been driven by radical shifts to alternative forms of energy and the significant capex associated with it.

Throughout my career, the story has been all about production growth, drilling, vast equipment; this has been where attention has been focused, but we are now in a scenario that requires something different.

It is disappointing large oil companies have only begun investing in renewables recently. Why aren't they at the forefront of alternatives? If they had focused on this 20 years ago, they could be in phenomenal positions. But now it is expensive for them to pivot, and they are perceived to be laggards and polluters.

Some commentators have suggested this could be the last major fossil fuel boom. Do you support that, or is it just naïve?

DF: We are going to experience a fine balance in the market between volume and price over the next few decades, and the question is what drag elevated energy prices could cause to the global economy. I don't expect this will be the last time I'll see prices at this level in my career.

Some energy majors say they will not increase the production of fossil fuels, regardless of price. Does that mean we are bound to experience greater volatility?

LW: The old oil majors have all been planning for production to decline, but we do anticipate increases (from listed companies) coming through from the US. It’s a difficult situation; in my view I don't think we have reached peak energy prices yet.

Are state-controlled actors going to be major beneficiaries?

LW: Yes – it will benefit countries like Saudi Arabia and others in major oil-producing regions. Prior to the conflict, Western oil majors were not in a position to increase production because of environmental concerns. We have seen a number selling assets to private equity, but private equity holders do not have much incentive to invest. They are more likely to try to milk those assets. If you are a consumer, you will simply have to pay.

DF: The reality is that demand in the crude oil market is above 2019 levels, and natural gas demand has never been higher. It takes years to create LNG export capacity, and many international players are unable to increase production, so the void must be filled by state players. Many could be viewed as having serious social and governance issues. The winners may be repressive governments and state-owned actors that may not view Western democracies in a positive light. Unfortunately, the consumer is often the loser and those towards the lower end of the income scale are the most exposed.

We need to think carefully about the energy transition. What happens if we move production from highly regulated markets with close oversight, with efficient greenhouse gas intensity production levels, elsewhere? We may not like the products being produced, but these companies are efficient at what they do. There are significant ramifications that come with activity moving to emerging markets which have higher geopolitical risk as well as incremental environmental risks.

One further consideration is the way in which some of these companies in developed markets are selling assets on to private equity, or other parties. Many of those firms raise capital in the markets I look at. While ESG is present, it is not a core competency and I do not anticipate it will become one in the foreseeable future. The reality is that many players are increasing production or intending to.

So, we have a situation where Shell or one of its peers removes a certain carbon footprint from its balance sheet by selling the asset, but that carbon has not been truly removed – it still makes its way into the atmosphere (a phenomenon dubbed as ‘shadow emissions’). We need to think about this carefully. Do we want Shell or Chevron or Exxon carrying out these activities? They are closely scrutinised and led by people who manage operations efficiently. Or do we want to shift production somewhere else?

What is likely to happen with energy prices so elevated?

DF: With prices at these levels, we expect the US shale response to kick-in, but there is a problem as you need infrastructure to get the product out to other parts of the globe, and that takes time. The key is that the demand trajectory has not yet moved to correspond with the International Energy Agency’s net-zero scenario, but supply has. That's the big disconnect.

In the short term, the world will look to producers like Saudi Arabia, the United Arab Emirates, Venezuela, Canada, and the United States to fill the void left by Russia. Unfortunately, this spare capacity cannot just be turned on like a spigot. The fastest response time will be seen in US shale, and we anticipate that in six to nine months. But we are talking about two to four million barrels per day that is set to come off the global market. That amount cannot be replaced by any single producer.

RS: We need to be honest, though. Some of the largest oil spills in history have been caused by the likes of BP and Exxon, and I understand Repsol has an issue in Peru. We cannot say these are just better companies – they have their own issues. For example, BP underinvested in health and safety for a long time driven by shareholder pressure for high margins, and that ultimately led to Deepwater Horizon. Shareholders are culpable in wanting to extract better margins, contributing to these issues.

Remember we are living in a world that does not have a carbon price. Once we start to see things like a carbon border-adjustment mechanism, there may be impacts on production and demand. And that’s when we will start to see wider, global impacts – on trade, and so on.

DF: In my view, those accidents were anomalies. Each one was unique. The reason only those large firms have seen such incidents is because regulators only allow sophisticated, well-funded companies to pursue these large projects. Moving forward we are still going to need some of these complex oil and gas projects to meet global demand (even under the IEA net-zero scenario).

But let’s focus on economics for a minute. The dispatch factors (i.e., ability to ramp up and down fast) of combined cycle gas-turbine plants in Europe are higher than anywhere else in the world. Part of that comes back to decisions made a few years ago, when the intention was to shutter coal production and, in some places, nuclear, as well. If you shut off avenues of power generation, it distorts the market. Power is not a free market, but these changes distort the ability to switch from one fuel to another depending on carbon intensity.

Germany has been on the path of shuttering nuclear, and many others are turning away from traditional baseload generation. Natural gas has the potential to step into that void and provide affordable energy with reasonable carbon intensity. However, we must consider methane leakage. If the industry cannot solve the methane problem, which contributes to warming, it does not deserve our capital. It’s an easy problem to solve. In the US, it should cost less than three per cent of capex. Leakage can take place during drilling, transportation or fractionation; you lose revenue and margin every time.