The Energy sector fell to its lowest weighting in the S&P 500 in 2019 as investors questioned the ability of E&P companies to deliver value and growth. As we move into 2020, the sector remains largely out of favor and new, more existential questions are now being asked around the industry's place in a carbon-constrained world. We discuss the energy investment outlook and identify both challenges and opportunities for the industry in our latest podcast with Roger Diwan and Justin Jacobs from our financial and capital markets research team, and Raoul LeBlanc from our North America unconventionals research team.

Jessica Nelson:
Recently, Larry Fink and his firm, BlackRock, the world's largest fund manager, published separate letters to CEOs and clients; suggesting that climate change will reshape the financial system. So Roger, let's start there today. Have climate concerns and ESG grown enough in importance to drive actions of the financial community going into 2020?

Roger Diwan:
Yes. I think there been a crescendo of discussion around these issues of ESG and energy transition over the last few years, but here we felt it really very strongly in the last year, where the questions from our clients and the need to provide that type of analysis has gone exponentially up. It has been already the case in Europe, but I think the United States has kind of joined that conversation. And what we're seeing here is the climate risks are really now on the agenda of the financial industry, and that is impacting very quickly the ability to finance, and to the funding of energy projects. So, the letter this week, in a way, put that front and center.

Breanne Dougherty:
Do you find that that's weighing in on your actual commodity price outlook yet? Or, is it really just focused on valuations of those upstream projects and the companies themselves? Have we yet started see it trickle through to the commodity complex?

Roger Diwan:
Not much actually. And you're right, this is an important question, because what we're seeing here in the crescendo of discussion around that is not reflective of what's happening in the energy business. The demand is still growing. Oil markets are not driven daily, and gas prices are not driven by ESG concerns. But the ESG concerns are really creeping up into the investment sentiment and in the willingness to own that sector, in the long-term. So, there's this dichotomy between the short-term, where it doesn't really have implication, but in the long-term, very much so. But the discussion has really moved to that long-term versus demand growth that we have in the short-term. Justin, what do you think about that?

Justin Jacobs:
Yeah, well, I think it has. I agree with that, but I think it has been part of the conversation over the last year, so demand has been weak over the last year. There have been some debates over how much the energy transition, the uptick in EVs, and stuff like that, has fed through some of the weak demand. I mean, our view is it hasn't really very much. It's really been an economic cycle-driven demand slowdown. But, clearly, it comes up where we meet with clients. People ask us, do you view this as something that's just a part of the oil market now, where these kind of demand-side uptakes and low carbon-side, is as a permanent fixture tamping down demand. Our view is that there's still some strength for the next few years on demand.

Roger Diwan:
Correct. I mean, this is a big debate right now. That if demand in 2019, which was very weak for oil, whether they are cyclical or structural issue, and the structural issue obviously coming from energy transition. And, the data, as Justin said, really tells it's much more cyclical issue around the economic cycles, rather than structural. If you think about the demand displacement created by EVs, we have right now on the road about 10 million EVs globally, for 1.6 billion vehicles. So, on the margin, it doesn't really yet have an impact. Maybe it's 20,000 barrels a day, correct? But that's not where the impact is, I think the impact is coming through the equity value. And, financial markets tend to react well in advance of these technological changes and start to try to price them. So, the question around the multiples and the strategies of the big companies around ESG, now is front and center and this is how it comes in.

Justin Jacobs:
Yeah. I think the financial sector is actually a bigger short-term catalyst for action on the industry-side, more than government regulation. Because that's kind of lagged, I think, the pressure from the financial side.

Hill Vaden:
Some questions Breanne and I were talking yesterday about, some of the MSCI ratings that I think BlackRock references in its letter. And we picked two companies at random, and Tesla and Suncor were both ranked equally, in terms of ESG ratings. So, it sounds like investors are still kind of unsure of exactly how to measure some of this. Does that delay make it harder to act on some of this stuff in 2020?

Justin Jacobs:
I think it does. In the short-term, that's a big issue. I mean right now, there's a sprawling kind of ecosystem of ESG data, and people are kind of picking and choosing different metrics, and there's no real ability to benchmark companies against each other. And, as you mentioned, these companies get equal ratings based on a very different kind of measurements. I think short-term, that is a big issue. I think that will work itself out over time. There's a lot of different, disparate efforts to standardize these measurements. I think that over time it will work itself out. But short-term, it's a big issue.

Roger Diwan:
Yeah, I agree. I think what to measure and how do you measure, it is going to be important. So, ESG has more than climate and carbon issues, but there will be indexes really looking at measuring the carbon footprint of each company. And obviously the oil and gas, and coal right now, really is in the eye of the storm. How this is measured, are you measuring just the emission from production? Or, are you measuring the full emission of what you got out of the ground? What we call the Tier 3 emissions. What you're consuming in your car, does it get allocated to the oil company which produced the oil, or not?

So, there's a lot of questions around that. We're early on. But what's important, I think, in terms of understanding the timing of the demand shift, which is very slow and very incremental, versus the impact of technological change and, almost, policy change. And how it's reflected, the technological change reflected in the devaluation through the financial sector, is really important. And, the squeeze is starting to happen early on. Correct? So, if you think about the big IOCs for a second, they're all trying to have a strategy about how to bring values and value to get it. Correct?

They're trying to meet the shareholder demand. They're about the company who have the highest yield return in the stock market, between 5 and 6%; and at the same time, they're telling their shareholders that they will become greener. And the question is, how do you deliver 5 or 6% into a different business model that you have not yet discovered?

Breanne Dougherty:
So, if we think about it though, as far as the pace of transition, and I think that what I'm hearing here, is it used to be back in the day that if we were in a low commodity price environment, and that meant growth for those commodities. That at the end of the day, you're going to make a decision as to what demand is going to be created, because these are cheap resources. We're looking at an extremely low global gas price environment right now, in the oil price environment. Although it's stronger than it was a couple years ago, it's not where it was quite a while ago. We do think that this momentum from the financial community, even in the absence of maybe, large policy being put in place, that this momentum for the financial community has the capacity to drive this forward, even though we're in this low hydrocarbon price environment.

Roger Diwan:
Yes. I think there's fundamental a problem, is how does financial market price technological change. And, how do you translate that to the value of the companies—both the one in the technology side and the one in the energy side? And that's what we're seeing right now. You're starting to see a transfer of value well ahead of this transition, in terms of the demand side. And, how you navigate that over the next five years will make and break some of these companies. Again, I think the example of Tesla is quite interesting. So, Tesla's value now is pretty much the whole rest of the auto sector, while they're producing a small fraction of the cars that the whole system is producing. So, the whole value has transitioned already, well before all of these other manufacturers are already transitioning their technology.

Justin Jacobs:
Yeah, I think you can already see that today in the way IOCs are investing. A lot of their short-term focus is still on the core oil and gas businesses, and you see that 90% plus on the cap backs is still going to this business. But that incremental 10%, that 10 years ago was going towards Arctic exploration or new heavy oil processing, kind of capacity and those kinds of investments, where you're trying to plant some flags in or creating platforms for future growth. That investment is now going into batteries, building outs, planting seeds of biofuels, or power-side utility, kind of integrated businesses. So, I think that's where they're kind of starting to build the platforms and future growth. So, it's a long-term process, and these are companies with long-term time horizons, but you're starting to see the impacts on the IOC-side today, in that regard.

Roger Diwan:
And I think the low prices also have had an impact. So, if you look at exploration, for example. Exploration budgets have really plummeted over the last five years and discoveries have plummeted. So, the question, have they just plummeted because of low oil price? Is it just because of shale—where you had discovered a lot of resources and you don't need to go discover? Or, you're changing the business model of these big IOCs and you are basically going to focus on producing from a small number of areas, where you have resources, and you're not really thinking 20, 30 years, in terms of replenishing your reserves.

Justin Jacobs:
Just to add, I mean, shale is kind of an ideal investment for them in this environment, because it's a quick payback on your investments. It's very flexible. So, you can move in and out, ramp activity up and down, in response to both commodity prices, but also, whatever kind of changes come on the regulatory front. Or from the financial community, on some of these energy transition issues. So, I think that's why you see a lot of investment going into the Permian and other shale from assets.

Listen to the full podcast online.

Learn more about our energy offerings for the financial sector.

This article includes information from an audio conversation and has been professionally transcribed as accurately as possible. Some words or phrases may have been unintentionally excluded.

Posted 03 February 2020.

This article was published by S&P Global Commodity Insights and not by S&P Global Ratings, which is a separately managed division of S&P Global.