Profiting From A Messy Energy Transition

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Everyone pretty much agrees that we will—eventually, at least—transition from a fossil fuel-powered economy to one powered by less polluting energy sources.

However, as this energy transition gains speed, the risk of chaos emanating from it is rising. Here’s why…

Today, investment in new oil and gas supply is well below what it was a decade ago. And investment in clean energy, though accelerating, is not increasing as quickly as it needs to.

Fast forward to a few years in the future and that could translate to a very large mismatch between ever-rising energy demand and energy supplies. The end result would be a replay of what we saw in the aftermath of Russia’s invasion of Ukraine, with energy prices rising rapidly, forcing governments to help their citizens heat their homes and fuel their vehicles—but magnified by several times.

As investors, here’s how we position ourselves for this possibility…

Oil Companies Are Not Investing Enough

A great article from the Financial Times’ Energy Source newsletter explained that one main reason for this is simply that oil and gas companies are just not investing as much as needed into increasing future production.

Despite record profits last year, oil and gas companies globally invested about $310 billion into capital spending. This was far lower than the $477 billion they invested in 2014. The rest of their profits went toward share buybacks, dividends, and paying down debt. If oil and gas companies had invested the same percentage of profits into finding more oil and gas as they did 10 years ago, the oil and gas firms could have invested an estimated nearly $600 billion.

There are a couple of reasons they did not. First, after many years of poor returns—especially in the shale sector—investors want to see their money coming back. But more importantly, the energy market is responding to policy efforts to cut down on future demand for fossil fuels.

Luisa Palacios is the co-author of a new research paper, entitled Investing in Oil and Gas Transition Assets en Route to Net Zero, from Columbia University’s Center on Global Energy Policy. She told the Financial Times: “What we’re looking at is an energy transition not where demand adjusts first—but an energy transition where supply adjusts first.”

So, while fossil fuel energy supplies are being adjusted downward—even as demand rises—we will need a bigger contribution from clean energy sources. However, investments there have not risen fast enough. They currently sit at a ratio of 1.5:1 compared to fossil fuels. Estimates are that this needs to increase to 9:1 by 2030 if net zero goals are to be achieved.

This all adds to a real mess on our hands in the near future with regard to energy as the transition happens…and it also leads to the companies that produce fossil fuels making a lot of money.

Energy Transition Winner

My favorite companies in this area continue to be the European oil companies, which are trading at much lower valuations than their American counterparts.

For example, Exxon and Chevron are valued at about six times their cash flow. That compares with about three times for Shell. And U.S. oil firms have a price-to-earnings ratio of around 8, while European oil stocks have a P/E of around 4! The reason for the lower valuations is ironic. Investors are rating these companies lower because they are slowly transitioning away from fossil fuels to clean energy.

Among the European majors, an interesting company is Norway’s Equinor ASA (EQNR), which produces more than two million barrels a day of oil and its equivalent, split evenly between oil and gas. Two-thirds of its output comes from its prolific Norwegian offshore fields.

European natural gas accounts for about a third of its total output, and most of it is sold on the spot market, benefiting from any spike higher in prices. But, unlike some of its European peers, Equinor plans to grow oil and gas production through 2026, at about a 2% compound annual growth rate.

The company made a record-adjusted pre-tax profit of $75 billion last year, thanks to all-time high natural gas prices. This helped it emerge as one of the biggest winners of the energy crisis, as Norway replaced Russia as Europe’s largest supplier of natural gas.

The $75 billion annual pre-tax earnings smashed the group’s previous record of $36.2 billion in 2008 when oil prices reached record highs of more than $140 a barrel. Adjusted earnings for the year after tax were $22.7 billion, up from just $10 billion in 2021.

Another company characteristic that I love is that Equinor has no net debt, giving it one of the best balance sheets among the major energy companies and leaving lots of room for dividend growth (current yield 8.26%).

Speaking of payouts to shareholders…the company said it would increase returns to shareholders to an expected $17 billion this year, citing its strong earnings, outlook, and balance sheet.

Equinor increased its cash dividend to $0.30 a share for the last three months of the year, from $0.20 a share in the third quarter, a 50% increase! It will also introduce an “extraordinary cash dividend” of $0.60 in 2023, and plans to buy back $6 billion of shares in 2023.

The proposed $17 billion of payouts this year is equivalent to around 18% of the company’s total market capitalization.

Like other oil stocks, Equinor’s stock has been under pressure and is down 4.25% this year to date. That gives us a nice entry point, at anywhere in the $29 to $33 range.

This post originally appeared at Investors Alley.