Friday, February 25, 2022

Goehring & Rozencwajg: "The Distortions of Cheap Energy"

We have posted excerpts from Goehring & Rozencwajg in the Links. Here are some excerpts from their Q4 letter, "The Distortions of Cheap Energy":
We estimate the US E&P companies will only spend $45 bn in 2022 – up from the COVID low of $30 but far below even 2019’s depressed level. The last time oil averaged $90 was 2014, a year in which E&P capital spending totaled $140 bn – nearly four times higher than we expect this year. The market needs more supply, but the normal clearing mechanism is being blocked by ESG pressures. Engine No. 1 secured three Exxon board seats in May 2021, despite owning a mere 0.02% of the shares outstanding. The fund waged a public campaign urging Exxon to slash upstream capital investment. Fearing similar shareholder activism, most energy companies have diverted spending away from production and focused instead either on returning capital to shareholders or on funding renewable projects.

These activist investors believe traditional energy will soon be eclipsed by renewables, both in terms of economic returns and carbon emissions. They talk relentlessly about renewable power’s declining costs and how someday renewables will compete with hydrocarbons in energy efficiency. They argue that this time really is different because of electric vehicles and that oil demand, after 160 years of relentless advances, will decline. They warn about the risk of hydrocarbon assets being “stranded as demand falters and investments made in long lived hydrocarbon asset such as oil sands will never be recovered. These activists argue that energy companies must stop spending on their upstream immediately or risk impairing their capital and instead must spend on renewable energy investments that will ultimately yield higher returns. They believe they are acting rationally in the face of changing technology, but what they really are doing is preventing the carefully choreographed energy capital spending cycle from taking place.

It is no coincidence that the proliferation of renewable energy occurred during a decade of abundant cheap energy and abundant cheap capital. As both resources become scarcer and more expensive, the inherent limitation of renewable energy (i.e., its significantly worse EROEI) will come to the fore. Our view is extremely out-of-consensus. In fact, most investors believe low energy prices have severely discouraged the adoption of renewable energy. When we ask what impact rising energy prices will have on renewables, the vast majority argue that higher energy prices will help renewables by making them more cost competitive. Most investors are under the impression that much higher energy prices will push renewables “into the money”--- that is renewables will become competitive for the first time versus higher priced hydrocarbons. This completely ignores the fact that energy itself makes up the single largest cost component for both wind and solar. Instead of making renewable energy more cost competitive, higher energy prices will simply drive up the costs. Renewables today remain “out of the money” and higher energy prices will never be able to push renewables “into the money.”

EROEI is not some abstract academic concept; it has huge impacts on a country’s economy and its ability to grow. Germany, after the Fukushima nuclear accident, decided to close all of its nuclear power plants. Nuclear power plants have the highest EROEI of any energy source (100 : 1) and nuclear power supplied almost 25% of Germany’s electricity. Much of the nuclear generated power was replace with renewables with EROEI’s of only 3 : 1. To any observer, there should be no mystery about why German electricity prices have surged by over four-fold in the last two years and why Germany is at the center of Europe’s energy crisis—it’s what happens when you replace an energy source with incredibly high efficiency with an energy source embedded with low efficiency.

Whether you look at absolute prices, the backwardation, producer stock prices or inventory levels, all the normal market signals are screaming for more oil. This in turn requires more upstream capital spending. Unfortunately, ESG pressures are serving as a block, preventing capital from entering the oil market and preventing it from balancing. There is little relief in sight. Capital spending at the 100 largest energy companies in the S&P 500 topped out at $228 bn in 2014 and had already fallen by a third to $155 bn in 2019. The COVID-19 pandemic drove capital spending budgets lower by another 40% in a single year to $91 bn in 2020. With oil prices nearing $100 per barrel, energy capital spending is only expected to reach $98 bn in 2022 and $110 bn in 2023 – half the levels in 2014 the last time oil was above $90 per barrel.

Many of our clients want to know about oil demand destruction. They want to know what oil price will impair global economic activity. This is a very difficult question to answer, but both history and theory can point us in the right direction. We have done a lot of work on the history of energy. Throughout most of human history, energy was provided by biomass with an EROEI of 10:1. This relatively low energy efficiency did not leave any surplus energy for growth. Neither GDP nor population grew until commercial coal deposits were developed in the seventeenth century (please see our video here to learn more). If an EROEI of 10:1 resulted in de minimis economic growth, what can we use this 10:1 number to infer about how high oil prices can go today? An EROEI of 10:1 means that 10% of all energy goes to sustain the energy supply. If energy is a good proxy for general economic activity, then an economy should stagnate once 10% of its GDP goes towards producing (and by extension consuming) energy. Evidence backs this up. Many academic studies suggest an economy will fall into recession once energy takes up 10% of total GDP – an empirical result that agrees with our theory.

In 2008, energy prices were approximately 10% of GDP right before the global financial crisis. If oil represents about half of all energy consumed, this means an economy will stall when oil represent about 5% of GDP. In 2008, the US consumed 18.8 m b/d. At $120 per barrel that equated to $823 bn or 5.6% of the $14.7 tr US GDP. The economy fell into recession shortly thereafter. In 2012-14, oil consumption never exceeded 3.5% of US GDP and prices stayed between $90 and $100 per barrel with no impact on either demand or economic activity. Today, oil represents less than 3.3% of US GDP and would have to rise to $140 per barrel before approaching the critical 5% threshold.

We have mentioned in the past that we have settled on long-life Canadian oil majors and royalty trusts for our energy investments. Some key concerns that informed this:
  • Avoiding (or benefiting) from escalating production costs, which other E&Ps will have.
  • Avoiding reinvestment risk / principal agent conflict with managements, which seems to be the key reason that the E&P sector fails to build value over time.
Oil sands are almost royalty-like, in the sense that (a) the capital costs are front loaded, unlike drilling wells, so they should benefit more from inflation than an E&P and (b) they have decades of sands to mine, so you avoid the forced reinvestment at inopportune times.


Anonymous said...

The problem with Canadian oil sands companies is there is a tyrant in charge of Canada.

CP said...

No investments in Russia - Canada is dodgy enough.

CP said...

"Oil sands are almost royalty like." - CBS

First, oil sands require hefty investment upfront but output holds steady for decades with relatively modest maintenance capital expenditures. The opposite is true for shale deposits, which take less upfront spending but, due to quick decline rates, require continuous investment into drilling and well completion to keep oil flowing. Capital expenditures have stayed relatively consistent for Canadian oil producers over the years—through boom and bust cycles—compared with U.S. producers, whose spending has fluctuated wildly. Thomas Liles, analyst at Rystad Energy, notes that, given the maturity of the oil sands sector, reinvestment rates, or the percentage of cash from operations spent on capital expenditures, should be in the 20%-30% range this year and next. That frees up a lot of cash for dividends and repurchases.