The two presidential candidates highlight opposing views with regard to the oil and gas sector; one supports the industry and the other is looking to accelerate the transition to cleaner energy alternatives. If President Trump were to be re-elected, we believe the status quo would remain and the current less-restrictive federal policy positions toward the energy sector would continue. Under a Biden administration, we believe the energy sector would likely come under increased scrutiny, but would unlikely see radical changes materially impacting the energy investment landscape in the near term. The potential change in public policy reflects a shift in public priorities, exemplified by an increased demand for more sustainable and environmentally friendly alternatives to traditional energy sources. The combination of public policy, technological advances and customer demands—three factors that remain subject to much debate—will likely dictate the path and pace of any clean-energy transition, in terms of both cost and ultimate success. We must, therefore, distinguish between short-term impacts and longer- term ambitions while acknowledging that the energy investment mosaic also extends beyond domestic policy and into foreign policy. Ultimately, we believe supply and demand fundamentals should reign.
The energy industry has endured extreme volatility in 2020 and the prospect of further tumult remains given the strength and timeframe of recovery, which is also subject to debate. Investor sentiment remains at a low point, reflected in low energy equity- and credit-relative valuations. Our near-term attention remains around OPEC+ supply management as the market seeks a rebalancing of oil supply with anticipated lower demand caused by COVID-19. This lower energy demand risk scenario is largely cyclical in nature, caused by a pandemic, but is now compounded by a growing concern over secular “peak demand,” given the rapid push toward renewable energy sources. We believe an important point to keep in mind is that while per capita energy intensity may be on the decline, total global energy consumption continues to grow, consistent with energy’s positive correlation with global growth.
The Shift Toward Green Energy
Renewable energy, often referred to as “green energy,” can be broadly defined as energy derived from natural sources, such as the sun, wind, water, plants and the ground (geothermal). While we believe traditional carbon-based energy sources, principally crude oil and natural gas, will continue to meet the majority of energy demand for years to come, countries are moving toward green energy at rapid speed. The shift to cleaner energy sources, however, has been underway for many years. This can be seen in the US electricity sector’s transition away from coal and toward natural gas as the key feedstock powering US electricity needs, driven by a combination of cost of supply and state regulation. We believe, in the intermediate term, state and federal policy will continue to target the power generation sector for emission reductions given the ability of green energy to demonstrate progress toward meeting net zero carbon goals. However, in our view, the decline of traditional oil and gas as a significant contributor to the energy mix is premature.
The implications of a transition to green energy continue to drive investor behavior and capital markets activity. Energy credit markets have shrunken considerably, with investment-grade energy representing 6.7% of the Bloomberg Barclays US Credit Index while high-yield energy has fallen to 13% of the BofA US High Yield Index, a decrease of 166 bps and 400 bps, respectively, over the last five years. This trend has already been observed in the equity markets with energy now accounting for just 3.6% of the S&P 500 Index, down from 15% in 2014. The implications of the lackluster investor sentiment include reduced access to both equity and debt capital markets and the necessity of new business models that prioritize profitability, self-funding, low leverage and returns to shareholders as priorities over production growth.
The Politics of Domestic Energy
US energy policy is at a turning point subject to the election outcome. Over the past four years under President Trump, energy policies have been supportive of the oil and gas industry as the theme of “US energy independence and security” has encouraged development of domestic resources for energy self-sufficiency and export-led growth. The Trump administration rolled back methane regulations via the Environmental Protection Agency, dialed back lower emissions and fuel efficiency standards for the automotive industry and expanded access to federal lands and waters, while also streamlining the pipeline permitting process. Regardless of the election result, both investor and consumer sentiment advocate for greater stewardship of the environment—changes we believe are permanent features of the energy investment landscape.
A Biden administration’s energy policy platform would be a material departure from the prior four years. The immediate action by a Biden administration would be to rejoin the Paris Agreement, committing the US to reduce greenhouse gas emissions with other objectives following thereafter. First and foremost, focus would be on the low-hanging fruit of power generation in the utility sector and concentrating efforts on renewable power generation to displace and replace more pollutive generation sources. During his campaign, Biden has introduced ambitious US policy goals centered around a zero-carbon electricity system by 2035 and net zero emissions by 2050. These objectives would be achieved through a national energy efficiency and clean energy standard (yet to be determined and likely to be defined via legislation). This would require a significant investment of approximately $2 trillion in “green energy” resources, new technologies and expansive green infrastructure, involving potential industry subsidies and incentives. A pivot to a more aggressive “Green New Deal” policy is possible and would be subject to how progressive the new energy secretary may be. We believe final policy changes hinge on whether Democrats have full control over Congress. While not specifically addressed, the means necessary to fund such a plan would likely call for a national carbon tax. However, we believe increased scrutiny over cost is also likely, as carbon taxes may have unintended consequences of raising costs to consumers given the taxes’ more regressive impact by nature. The irony we see in this agenda is that over the shorter term more energy, specifically natural gas, may be required to accelerate a transition to cleaner fuels and meet emission goals.
Looking into the broader possible Biden agenda, we anticipate existing drilling permits on federal lands to be reviewed and for new permitting likely to be slowed but not halted. Consequently, oil and gas production growth on federal lands would be reduced, but unlikely to materially impact the overall US oil and gas supply picture. A possible wrinkle in this is the potential to grant waivers where Democrat-run states would be adversely impacted from a revenue perspective if such activity would be curtailed. Beyond the permitting process it is reasonable to assume methane emissions, flaring and water use and recycling would garner increased attention. While Biden has already walked back a complete ban on “fracking” the potential to limit such activity is possible. The overall result, however, would be a material slowdown in oil and gas production activity, and an increase in the industry’s cost structure. This in itself would incentivize participants to restrain capital investment and production would fall thereafter.
The Evolving Energy Sector
Notwithstanding the election overhang, the energy sector, independently, has already been subject to transition forces over the past several years. The concurrent unprecedented demand and supply shock has focused corporate managements’ attention inward; controlling what they can control amid a continued difficult macro backdrop. Given restrained capital markets, capital discipline has gripped the industry with capital budgets currently at unsustainable (below maintenance) levels. The forced discipline translates into lower activity levels as rates of return are challenged with lower realized prices below incentive prices.
Not all is lost, however, as a smaller, leaner industry is still able to benefit. From a credit investor’s perspective, improved capital discipline and capital spending reductions are well underway as companies prioritize debt reduction and improved balance sheets in lieu of higher commodity prices. The prospects of greater future regulatory oversight should also hasten industry consolidation in a drive to lower costs and increase scale and investor appeal. Higher investment hurdle rates and lower production levels may well translate into higher prices in the future. Further, the energy transition is not likely to occur overnight; it is likely to be a more methodical, phased approach but also subject to consumer demands. On the other hand, global economic growth and increased economic prosperity requires more energy and the lowest cost sources tend to be first consumed. Transitioning to higher-cost forms of energy may place a drag on (recovering) economies and stymie growth over the shorter term. The pace of transition remains subject to debate. Furthermore, to achieve stated climate goals, policy choices may stress the commodity value chain and inadvertently add more expense to the transition cost equation via higher price volatility. We believe the absolute level of fossil fuel consumption may not change over the short to medium term but we expect the mix of energy sources will continue to change given the move toward renewable energy sources.