ay was a cruel month for oil companies. Over the past month:
1. A Dutch court ruled that Royal Dutch Shell, PLC (Shell Oil) must comply with the Paris Climate Accords and make immediate, aggressive cuts in carbon emissions.
2. The International Energy Agency (IEA), traditionally a strong supporter of fossil fuel industries, published a report calling for an immediate end to all new investment in oil and gas wells.
3. A consortium of the world’s largest investment managers voted to place two environmental activists onto Exxon’s board of directors.
4. Ford launched an electric version of the bestselling vehicle in the world (the Ford F150 pickup truck) while General Motors committed to offering exclusively electric vehicles by 2036.
We think each of these events in isolation would be important. Taken together, they appear to mark a critical turning point in the debate over global warming. The oil industry has been the epicenter of that debate. Developments over the past month suggest the oil industry is losing the battle against sweeping restrictions on carbon emissions.
The global economy’s 150 year dependence upon oil will not end in a single month, year, or even decade. However, we think May’s shocking series of blows against the oil industry represent a trend that will continue to accelerate. If we are correct, then investors are presented with significant opportunities and risks as the world transitions to new modes of power generation.
The equivalent of the US Supreme Court in the Netherlands ruled that Shell Oil must conform to the carbon emission targets set by the Paris Climate Accords. The ruling contains two earthshaking provisions.
First, a court has found that private companies must comply with the treaty commitments of their home country. Second, Shell’s carbon reduction obligations extend beyond its direct emissions. Shell must also reduce the carbon emitted by its products after they have been sold. Effectively, Shell is now responsible for the carbon emissions from every car that fills up with Shell gasoline.
Shell is clearly going to appeal this ruling and the final resolution will not be known for many years. However, environmentalists can be counted on to file similar lawsuits with similar provisions against every major oil company. Uncertainty over the outcomes of this litigation will likely depress the ability of oil companies to invest in future projects and raise their cost of capital for the projects they do undertake.
Oil companies are used to fighting environmental activists. However, in recent weeks traditional allies at the IEA and giant asset managers like Blackrock and Vanguard have also turned against them.
The IEA is an energy research organization that was formed by Western democracies during the oil crises of the 1970s. Its research is widely respected on both the political left and right. The IEA’s 2021 flagship report, Net Zero By 2050, is uncharacteristically blunt in its recommendations. The report concludes that investment in new oil and natural gas projects must stop immediately, and petroleum powered vehicles should be eliminated by 2035.
The IEA the has no regulatory or legislative power. However, the agency’s reputation for unbiased research makes it more difficult to describe ambitious carbon reduction goals as radical or out of the mainstream. When IEA recommendations are more restrictive than those of the Green New Deal, investors should recognize that consensus on this issue is moving sharply against oil companies.
The recent proxy votes major asset managers provided to environmental activists were perhaps even more shocking than the IEA report. A small hedge fund devoted to environmental activism. Engine No. 1, ran a slate of 4 candidates for seats on Exxon’s board of directors. Giant asset managers like Blackrock, Vanguard, and State Street supported Engine No. 1’s slate of candidates. As a result, the upstart hedge fund took 2 of the 12 seats on Exxon’s board.
This proxy fight has bigger implications than just the presence of environmentally friendly voices on the Exxon board. This proxy fight signals a potential end to the long standing “Wall Street Rule.” Under the Wall Street Rule, asset managers do not try to influence corporate governance through their proxy votes. If they do not like the decisions a company is making, they sell the stock rather than try and take control of the board.
Blackrock, Vanguard, and State Street are dominate players in Exchange Trade Funds (ETFs). ETFs are primarily passive, index oriented investment vehicles. That means ETF managers cannot simply sell Exxon stock when they disagree with management strategy. Instead, the Exxon proxy fight suggests these asset managers will use their proxy voting power to force oil companies to adopt more aggressive global warming strategies.
The end of the Wall Street Rule is likely to improve corporate governance and reduce the tendency for corporate boards to rubber stamp management initiatives. For Big Oil, the immediate impact of more shareholder input into corporate decisions is a potentially expensive change in strategic direction regarding global warming.
Perhaps Elon Musk’s most astute analytical conclusion, in a career full of brilliant insights, was that consumers would buy electric cars not to save the planet but because they are better cars. Tesla has established that electric cars are faster, handle better, and are vastly more reliable than gas powered alternatives. Gas and diesel powered cars continue to offer better range and long distance driving capacity, but as battery and recharging technologies advance even these remaining advantages could soon be eliminated.
Ford and GM have accepted the Tesla view of the future. Both companies are investing tens of billions over the next few years to become competitive in the electric car space. GM is by far the most aggressive of the traditional auto companies by pledging the elimination of internal combustion engines by 2036. However, virtually every car company around the world is committed to being majority electric within the next 10 years.
The move toward electric cars has obvious implications for gasoline and other so called “downstream” petroleum product sales. Downstream sales, including automotive gas and oil products, account for about 80% of a typical oil company's total revenue.
These downstream could decline sharply as consumers move to electric cars. Oil companies no longer own their retail distribution networks, and the Biden infrastructure bill could further impede gasoline sales by helping gas station owners convert to charging stations. Oil companies are seeking new markets in carbon recapture and charging station technologies, but may struggle to ramp revenue from new offerings fast enough to offset declining gasoline sales.
Legal risks and pressure from activist investors could reduce investment in new oil production, although we doubt these restrictions will go as far as the outright elimination of new oil and gas wells called for by the IEA. Even so, fracked wells in the US tend to have short production lives and investment in new wells is required to maintain current production. To the extent that new investment is restricted, US production could fall and provide more pricing power for OPEC and Russian alternatives.
This may explain why OPEC and Russia have allowed oil prices to rise above the breakeven thresholds for US producers. They may believe that external forces will keep frackers from taking advantage of higher oil prices through higher investment and higher production.
Energy names have been star performers in 2021, with big integrated oil companies like Exxon up about 40% year to date. More aggressive exploration and production stocks are up more than 50%. These gains were mostly earned in the first few months of 2021, and energy names have largely chopped sideways since their March peaks despite a breakout in oil prices. We think this divergence between oil prices and oil company stocks could continue.
The combination of higher oil prices and investment restrictions could, ironically, produce record profits and cash flow for Big Oil. If devoted to dividends, this cash flow could make oil stocks attractive income investments.
Unfortunately, company managers plan instead to invest much of their cash flow in new products and services outside of petrochemicals. The history of such industry and company transformations is not encouraging (film photography, mainframe computing, department stores, etc.). Despite our bullish outlook for oil prices and oil company cash flow, we believe the 2021 bounce represents an opportunity to lighten exposure to the petroleum industry.
Tesla loses money on every car it sells. The company turns a profit because it receives government subsidies that encourage electric car purchases, and it sells carbon credits to other automakers who have not met various government targets for electric car production. As other automakers ramp up electric car production, both revenue sources could be at risk. Subsides that encourage electric car purchases might become prohibitively expensive as more consumers opt for electric cars.
As other car makers produce their own electric cars, they will not need Tesla’s credits. Industry long term profitability is very much in question. Investors should understand the risks entailed in chasing Ford and GM after their big gains in 2021. We are also skeptical that Tesla can grow earnings fast enough to justify its 600x+ price/earnings multiple.
When economy wide transformations like the decline of Big Oil occur, investors may be tempted to speculate on revolutionary technologies best positioned to benefit from that economic transformation (battery products, charging station technologies, etc.). Sometimes, the most obvious and boring beneficiaries are overlooked in the speculative frenzy.
Electric utilities typically have a monopoly on power distribution within their geographic region. As electric motors replace internal combustion engines in our vehicles, these regional monopolies will almost inevitably see substantially increased demand. Although utility rates are strictly regulated, utilities are highly leveraged both operationally and financially.
That means big increases in demand could lead to even bigger increases in cash flow. Despite historically low borrowing rates for these highly indebted companies, the stock prices for most utilities remain well below their pre-COVID highs. At about 20x expected 2021 earnings and with 3% dividend yields, utility stocks appear to be a boring but potentially profitably way to benefit from the decline of Big Oil.
As the auto industry moves from gasoline powered to electric powered cars, the differentiating skill set changes from mechanical engineering (a third grader can build an electric motor) to software engineering and hardware integration. Tesla can upgrade its vehicles through software releases, something no traditional auto maker can achieve.
Tesla enjoys this huge competitive advantage thanks to its carefully engineered hardware and software integration. Google has acknowledged that they are developing a software platform offering automakers a similar partnership to the one Android provides for phone handset manufacturers - Google handles software design and the automakers focus on hardware integration.
Apple has been more circumspect, but analysts suspect that Apple is mimicking Tesla by developing both the software and hardware for a seamlessly integrated electric car product. To keep growing given their respective market capitalizations (about $2.0 trillion for Apple and $1.6 trillion for Google), both companies need new products with trillion dollar potential. Pushing into the electric car market could provide both companies that next trillion dollar market opportunity.
May’s shocking series of legal, corporate governance, and marketing decisions point to a grim future for the oil industry. These developments were not driven by politicians and therefore are unlikely to be reversed at the next election. Instead, each of these developments suggest that the legal, scientific and consumer consensus has moved strongly toward significant carbon emission reductions and dramatic reductions in the long term demand for oil.
We believe the past month marked a turning point, after which the momentum of events will accelerate. Oil companies are likely to become increasingly besieged by external events like tobacco companies were in the 1980s and 1990s. The critical difference between Big Oil and Big Tobacco is that, unlike tobacco addiction, innumerable alternatives exist that can substantially reduce our current dependence on oil.
Oil is intertwined in every aspect of modern consumer lives, from the vehicles we drive to the plastic packaging of our food. This dependence cannot be reversed simply by winning a court decision or a proxy fight. However, equity market prices are determined by a company’s long term prospects for earnings growth and return on investment. We believe that as investors absorb the long term implications of the past month’s events, market valuations will start anticipating the end of Big Oil.