Chicxulub: The Early Losers in the Energy Transition

Short the Horses Redux

In any major industry transition it’s supposed to be easier to spot the losers than the winners.

Winners are very tricky to identify at the outset, because as a new technology emerges it is not even clear which part of the business model is going to prevail: is it the raw material producers, or the manufacturers, or the distributors or some fiendishly clever combination of these?

But the losers are an obvious bunch –  the ways of doing business are settled, and the dominant (read suddenly vulnerable) incumbents familiar and well-studied.

We have discussed this investment strategy asymmetry at length here: summed up by Warren Buffet’s pungent strategy for investing in the US transport industry a century ago: “short the horses”.

His advice would be to sell shares in dominant companies with outdated technologies – as a group – as they are all bound to fall in value.

And so to energy.

Despite the large volumetric dominance of fossil fuels in world energy, their economic performance over the past 5-10 years has been troubled by a mix of demand and supply shocks.

Demand has been curbed by the end of China’s era of industrial hyper-growth, along with international policy initiatives aimed at reducing fossil-fuel dependence for reasons ranging from climate impact to national security.

And supply has been structurally upended by the sudden emergence of global-scale manufactured energy – wind, solar, and battery storage – championed by large energy importers such as China and the EU.

All sectors of the  fossil fuel industry have been affected.

The coal industry suffered major corporate bankruptcies in 2015-16 as global consumption peaked in 2013 and then fell.

Global natural and LNG gas prices have fallen over 50% in the last 3-4 years as supply outstripped demand

Oil prices have fallen 45% over the last five years from the same mismatch.

The risks of this industry dynamic continuing are high.

Annual fossil-fuel consumption, as a whole, may not yet have mathematically peaked, but that milestone is likely a formality in the next couple of years, whilst the fossil fuel business continues to convince itself greater supplies are required.

In their Vision 2020 analysis, Carbon Tracker, a think tank, framed this fundamental transition, from fossil fuels to manufactured energy, in the four phases that financial markets use to analyse business sectors: innovation, peaking, rapid change and end-game.

Innovation measures the emergence of manufactured energy (2010 until now), Peaking the decade ahead as incumbent fossil fuels hit a maximum, Rapid Change from 2030-2045 as massive restructuring occurs, and then Endgame: from 2045 onwards the deep replacement of fossil fuels even in seemingly hard-to-change sectors such as aviation and petrochemicals.

If the transition is following this path, financial theory predicts markets will begin to react now, during the peaking phase, by starting to retreat from investment in the declining incumbents.

To echo Buffet; there should be some pretty obvious “energy horses” to short.

The Short List

As Buffet also noted, you really should short sectors, not specific, individual companies (which is just picking winners in reverse: shorters of Tesla – how is that going ?)

Looking for the energy transition horses we have deliberately by-passed the related energy sectors of utilities (often highly regulated or with major local factors) and automobiles (a very different set of dynamics), and focused on the fossil fuels sectors directly.

We will also sidestep the coal sector as it has, as noted, already collapsed in a series of bankruptcies (despite recent rebounds post-restructuring).

So let’s home in on the oil and gas sector directly as a large opportunity  to short.

If a transition is underway per the Vision 2020 model, and the market is anticipating sectoral decline, we should start to see a sustained lagging performance by energy stocks against the general market index.

What timeframe to use ?

We’ll use the last five years  – tracking the end of the Chinese megacycle, and the emergence of the new technologies at industrial scale.

However,  a key issue here is that oil stocks, unsurprisingly,  closely follow oil price.

Shorting the high-level oil and gas sector might be economically correct,  but forever doomed because in effect you are trying to predict the direction of a complex, irrational system – the business model of long-cycle commodity corporations multiplied by the geopolitics and cartel actions of oil producing nations.

Good. Luck.

Thus, against a backdrop over 50% gains in general market performance since 2013, but a 45% drop in oil prices, the S & P  Global Oil index fell just over 10%.

Large oil and gas companies act as a moderated proxy to naked commodity prices via integrated portfolios of upstream (exploration and development) and downstream (refining and marketing) business divisions.

Add to this ongoing production interventions by OPEC and Russia to generate price corrections.

Shorting against this structure would have required large cash-piles and an equal amount of fortitude over the past five years – and all for perhaps a 10% return before fees.

So far, so typical.

Indeed, it is likely investors are still attracted far more to the long side no matter any scent of sectoral decay.

With the Great Man theory of oil price resurgent (see here), certain groups of stakeholders willl be willing to overlook long-term growth prospects, and focus instead on the prizes from near-term exposure to geo-political events and cartel reactions.

Darwin’s Horses

Look deeper into the oil and gas supply chain, however, and shorting options become more viable.

 

Note: S&P General Index, Global Oil and Gas Index and Oil Field Services Index, Dec 2013 – 100. Other equivalent indices show similar trends eg Philadelphia Stock exchange for OFS, PHLX. OSX, and Nasdaq Oil and Gas indices.

Whilst the IOCs have moderated the latest price swings so far, the index of their engineering, equipment and construction providers has not fared as well: the Oil Field Services index is down 60-70% (depending on the index used), well below the 45% oil price slump, and the 10% decline of the integrated majors.

Why ?

Let’s take a step back; in the previous five years to 2014 oil field service (OFS) firms had actually out-performed large oil companies.

This was the golden era of mega-projects and multiple years of prices north of $100/bbl. All industry boats, the producers and supply chains behind them, were lifted, with the supply chain pulled highest due to rampant demand for their specialised capabilities and limited resources.

But post 2014 and the oil price slump, whilst fossil fuel demand still grew at lower rates,  the need for any more exploration, engineering and construction infrastructure quickly dissipated – the massive build-out of plant and pipeline required no major additions in a world of softening volumes.

The oil and gas supply chain, which includes large global companies such as GE, Technip, Halliburton, KBR and Schlumberger, differs in a fundamental way from the IOCs, making then far more exposed to the front-end of fossil fuel disruption.

Their income largely depends upon the capital expenditure of the IOCs, having increasingly adapted to it in Darwin-like fashion over the years, in a bid to achieve competitive advantage.

When this rich liquor of IOC expenditure dried up post 2014, as oil company annual budgets were squeezed by over 35%, service company top-line income and profits collapsed.

For the IOCs, oil price mood swings can mean instant damage, but also instant repair to cash and profit.

But in the supply chain the cancellation and continuous delay of capital programs can mean months or years of revenue impairment.

For all their engineering heft, service firm balance sheets are far leaner than those of oil and gas companies, and average market capitalization is only 5-10% of IOCs.

Even in a slump IOCs can still reap the rewards of increased cash from new (and paid-for) operating assets with their fresh production: but the supply chain firms must wait obediently for more investment orders to arrive before revenue holes can be plugged.

The damage to these firms can be existential.

Highly-specialized supply chain companies such as CGG, which focuses on exploration technologies, and Weatherford which supplies customised drilling equipment, or even broader-based firms such as Saipem which rely heavily on future construction projects have effectively gone bust.

The share prices of all three are down over 90% since 2013.

The market seems to have already recognized this asymmetry – between the forward-revenue based service sector and the complex, volatile, near-term driven oil and gas producing masters.

A big short on the oil and gas service sector in the summer of 2014 would have worked well over the past five years.

The chart below shows how various other short plays would have worked out over the same period.

Source: Various – Google finance; FT.com;, Nasdaq.com

Shorting the general stock market index would have been a terrible idea.

Shorting anything else oil and gas sector-related– from a general IOC index through heavy oil stocks (represented by Canadian firms Cenovus and Husky Oil) to the oil service supply chain – would have worked.

Shorting the far-future minded stock of exploration seismic technology firm CGG would have been the biggest winning bet of all.

Have we found the energy horses at last?

Hold fast.

The IEA, a large industry think-tank, still expects the oil and gas business to quickly return to high investment.

It reasons that the current spend downturn is storing up yet another supply crunch as declining fields confront remorseless demand and generate a new price surge.

There are no energy horses, only temporary industry reversals.

The cycle prevails.

The wise investor should bail out now, take her transitory win, and reinvest in the coming upswing.

Stranded Thinking

Unconvincing.

The prevailing industry logic seems an increasingly hazardous bet.

Although oil and gas industry price cycles have occurred empirically for a long time there is no deeper energy law at work ensuring their immortality.

They are just a large-scale feature of our thermal-based system which is based on commodity fuels.

To assume otherwise is “stranded thinking” in the withering phrase of Carbon Tracker’s Kingsmill Bond.

New technologies are changing the commodity-dominated context of global energy.

The rise of competition from wind, solar and various forms of battery electricity are creating energy of a totally different energy kind.

The energy they produce is via technical conversion of infinite universal resources (light and wind) allowing the economic substitution of thermal power with electrical power.

The majority of marginal energy growth, where investment dollars focus, is switching to these new technologies, as they devour demand gigawatt by gigawatt, and gallon by gallon.

Meanwhile the international oil and gas industry continues to tell itself that despite all this change, it still needs to build more production capacity to guard against field decline rates, and satisfy future consumption of its product.

This compulsion continues despite the fact that output from the investment binge of 2005-14 is still to play out – with newly commissioned, delayed and part-finished fossil fuel behemoths still coming on-stream, such as here and here.

Plus the clear intent of US shale and OPEC to continue to spend heavily.

And as even the industry cheerleader the IEA predicts the peak of global gasoline consumption by the mid 2020s.

Even though the IEA uses magical arithmetic to find a way in which minor oil barrel fractions make up for the loss of gasoline growth, the long-term decline of oil’s most iconic product will be a huge psychological and symbolic blow for the business.

It will also make for gloomy headlines, and mark the shift to a new era.

All this describes a world in which most international oil firms, despite scenario bravado, will hesitate to invest given the stockpile of assets amassing behind them.

In all likelihood, many will quietly hold back expenditure, and hope the OPEC-Russia cartel restraints, and geopolitical events will their work timeless enchantments on cash-flows.

For their exquisitely-adapted supply chains this will mean further secular decline and more restructuring.

Chicxulub

The established energy system’s structure is beginning to weaken, commencing with its far-future divisions of exploration and construction – and then more generally toward the oil and gas producers themselves.

How the supply-chain sector performs over the next year or so will be a window into the hard-core beliefs of the oil and gas majors.

If it rebounds, the transition may be further off than supposed: long-term fossil-fuel investment and future demand much more resilient (and wind/solar and batteries less competitive) than predicted.

However, if it continues to deteriorate, as looks much more likely, it will be acting as confirmation of the structural shift underway – from an energy system based on commodity fuels, to one based on manufactured technologies.

From the volatility of commodity price cycles and regional politics, to a more level realm of technical product efficiency and global innovation.

So – here are all the horses, in plain sight, still refusing to take defensive action.

But perhaps sensing a threat not yet visible, though increasingly felt.

Their Chicxulub.

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