Oil Prices and the Ripple Effects of ESG

Questions about environmental, social, and governance (ESG) issues are becoming central to commodity markets and capital allocation discussions.

Environment, social, and governance factors have been playing an important role in commodity markets since long before the term “ESG” became popular. Policies over the years have included standards for automotive emissions, efficiency, and renewable energy fuel content, as well as renewable fuel mandates for power production and direct carbon taxes and cap and trade for manufacturers. The most recent and salient policy for markets is the International Maritime Organization’s global mandate to migrate from 3.5% sulfur in global shipping fuels to 0.5% sulfur. Such policies targeting emissions reductions and fuel efficiency standards have significantly altered supply, demand, and pricing in the commodity markets, creating both risks and opportunities for active investors. While ESG-related considerations and the commodity markets have long been intertwined, growing investor awareness of ESG concerns, as evidenced for example by the theme of the 2020 World Economic Forum in Davos, has made them central to capital allocation discussions.

One common thread to the aforementioned policies has been the stated intention of policymakers to weaken hydrocarbon demand, particularly for petroleum and coal.1 These policy-driven impulses, along with recent improvements in new energy technologies such as electric vehicles and declining prices for renewable power sources, have greatly depressed sentiment among many market participants about the future of hydrocarbon demand, raised the specter of stranded producing assets and depressed expectations for future prices.

Further, concerns about the future of hydrocarbon demand stemming from environmental concerns – along with the realization by some that most oil and gas producers generally have not been good stewards of capital or sufficiently reoriented their business models to a low-carbon economy – have driven both public and private capital away from the oil patch. Drilling levels have dropped to two-year lows (according to Baker Hughes), and capital budgets are being slashed as investors begin to demand better governance from exploration and production (E&P) companies. Many pensions, endowments, and sovereign wealth funds are divesting upstream producing assets. The net effect of this flight of capital is evident with the energy patch share of the S&P 500 falling to the lowest level in over 20 years. In some respects, the distress in the U.S. E&P patch is not unlike what was witnessed in 2016 when prices were half the level of today; looking ahead, the upcoming debt maturities of E&P companies over the next three years raise questions about the viability of their business models. Even the European Investment Bank announced it will no longer fund projects producing or consuming hydrocarbons after 2021.

This reduction in capital availability will likely have long-term consequences, since the oil and gas business is very capital-intensive, requiring substantial funding and person power to just keep output flat, not to mention meet the rising demand that is foreseen over the next 10 years. As we look to 2020 and beyond, this decline in investment should be quite supportive of oil prices overall and give rise to potentially interesting private investment opportunities as companies are forced to shed assets to repair balance sheets. In addition, as the political season heats up, the prospects of more draconian limitations to oil and gas investments cannot be fully ruled out, which would be a truly bullish development for commodity prices. Given the “roll yield” (i.e., the potential return generated by rolling a higher-priced short-term contract into a lower-priced longer-term contract) for owning oil is north of 8% as of 23 January (per ICE), the tailwind for a commodity investor is material.

For more insights, please read Energy 2020 Outlook: Five Key Investor Questions.”

Greg Sharenow is a portfolio manager focusing on commodities and real assets and regular contributor to the PIMCO Blog.

1 The transition of marine fuels to lower-sulfur specifications is the exception in the list and is a bullish catalyst in the oil market currently, at least for low-sulfur crude oils such as WTI and Brent and low-sulfur refined products geared for the shipping industry.
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Greg E. Sharenow

Portfolio Manager, Commodities and Real Assets

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