Podcast Transcript - Arjun Murti - ESG Mini Series

04/11/2021

Juan Torres Rodriguez

Juan Torres Rodriguez

Fund Manager, Equity Value

Alexander Monk

Alexander Monk

Portfolio Manager, Global Resource Equities

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To coincide with the UN Climate Change Conference – or COP26 for short – which is happening in Glasgow this month, we are launching a short spin-off series to The Value Perspective podcast, focusing solely on environmental, social and governance or ‘ESG’ considerations. This is a discussion we have become very familiar with as it has been a hot topic for the investment sector for the past couple of years but in this miniseries, which we will release on Thursdays, we are specifically interviewing experts who approach ESG and sustainability issues from a different angle or challenge some conventions within the field.

Our next guest in this series is Arjun Murti. Arjun is a member of the ConocoPhillips board, a senior adviser to energy transition investors and a former partner at Goldman Sachs. He discusses with The Value Perspective podcast regular Juan Torres Rodriguez and Schroders fund manager Alex Monk the history of energy transitions, the role traditional energy companies have to play in the climate change debate, hydrogen and renewables within the traditional oil and gas sector, as well as his outlook for energy companies in the future.

JTR: Arjun Murti, thank you very much for being part of The Value Perspective podcast. It is a pleasure to have you here. Could we please start by hearing a little bit about you,  your background and how you came to be an expert and investor in the energy sector.

AM: It is really by chance – my career has been almost entirely as an equity research analyst who happened to have been focused on the oil and gas sector. It certainly was not on purpose but my first job was at a small investment bank in Denver, Petrie Parkman, which specialised in this space and I kind of fell in love with it. It was a global sector, I enjoyed travelling around the world, understanding how different countries could impact oil prices everywhere else in the world and I have continued throughout my career with that.

So I was on the ‘buy’ side at J.P. Morgan Asset Management for four years and then the bulk of my career was at Goldman Sachs. I was a ‘sell’ side equity research analyst, I became a partner and I ended up co-running the Americas equities research department. I left Goldman in 2014 and, since then, have been an advisor at a private equity firm, I am on the board of ConocoPhillips and am I an advisory board member at Columbia University Centre on Global Energy Policy, which is a nonpartisan public policy think tank.

So I have really enjoyed this sector and the Goldman experience highlighted that I did not like research management, for sure. I love being an analyst and I would say, historically, it was more oil and gas focused. That has morphed, of course, into clean energy, renewables and all the energy transition and climate stuff that now impacts the world, as well as the traditional newer sectors today.

JTR: It is interesting that you made the transition out of equity research in 2014 when energy was pretty much making a turn south.

AM: You know, my successor at Goldman gives me credit for my dropping coverage of the sector when oil was still priced at $110 in July 2014. You can only go through so many of these cycles as a public equity analyst, if you will, and I probably was ready for just a little change of pace. I really love this post-Goldman life, with a portfolio of activities in and around the sector without one permanent home. I actually would advise that to anyone in a position to do so.

JTR: Energy as a percentage of pretty much any index in the world has declined a lot – what was that transition like to go through?

AM: It is remarkable. Again, my career started in 1992 and, from that point through to 2014, when I stopped at Goldman, if we look at US markets – and I have been based in the US, and really in New York, for the vast bulk of my career, though at various times I have looked at the global sector overseeing those teams – in the S&P 500, as an example, energy has traditionally been 8% to 15% of the index with the bulk of that weight driven by the major oils; by Exxon and Mobil and Texaco and Chevron and all these types of companies that, of course, have merged into just a handful of names.

But it was always a critically important sector and my standard line on that is, if you look at Exxon Mobil, this of course used to be Standard Oil and, from the point it was broken up in 1911 by the US government, up until really the last five years, it was a top-three stock in the S&P 500. It was Standard Oil Company New Jersey, which became Exxon, which became Exxon Mobil and through all the ups and downs – through World War One, World War Two, the Korean War, the Vietnam War, the Arab oil embargo years of the 1970s, the bust of the 1980s and 1990s, the supercycle of the 2000s – through all that the company was a top three stock.

When Exxon started teetering – when they made some perhaps not-so-good investment and acquisition decisions – the sector followed its lead and it has gotten left behind and, for the first time in my career, the traditional oil and gas space is an irrelevant portion of the S&P 500. It is 2% to 3%. So when I speak to companies, they are always worried about their competitors, where they should invest, what is the right dividend policy, I tell them, your biggest risk is actually investor irrelevance – that people do not care.

Steel is still an important sector but does anyone live and die by what happens to steel companies or aluminium? Maybe a little more right now today, as we are talking, when there is talk about commodity and energy shortages. But I do worry, from the perspective of traditional companies, they have fallen to the point of irrelevance although it does not have to be this way – they have in part chosen this path through a variety of different, unfortunate decisions they have made but there is a path back.

And we may be at the beginning of that. And I think time will tell if they can get back to a more respectable weighting. What is true in the US is also of course true in Europe and other parts of the world in terms of the diminished relevance for investors of the traditional oil and gas space – and the big question is, are we at a positive inflection where they can fight back to at least a modicum of credibility?

AlexM: You mentioned that the traditional energy majors have become more irrelevant in terms of their positioning in the global market and I guess part of that is because we are potentially about to go through the third great energy transition we have experienced through history – the first being the move away from biomass into coal and the Industrial Revolution; and the second being the shift to oil and gas and automobiles in the early 1900s. When you look at the world today, where do you see our energy system in 30 years’ time? What does our energy system look like in the future? And do you think we can meet these net-zero goals being set around the world?

AM: I want to answer your net-zero question but I might push back slightly on the premise of your question. I think the number-one issue plaguing the traditional oil and gas space has been the poor profitability it generated over the last decade. I would say that has been the overwhelming driver for its diminished investment relevance at a time when other sectors, especially technology and those types of high-growth sectors in what has been, let’s call it, a secular stagnation-type GDP environment, have been able to perform very well.

I would say a huge portion of the industry’s problems has been the self-inflicted wound of bad investments and poor profitability. For sure, there is a question on what is the long-term outlook for oil demand and natural gas demand and are we going to transition away? And that might be putting some compression on, let's say, terminal value calculations. But, again, the overriding ‘miss’ has been one of poor profitability – and I think that is in the process of turning though that remains to be seen.

But let me get to your net-zero question. My personal view is the world absolutely should be looking to transition to lower carbon-intensive forms of energy and to have this goal of net zero by 2050 is an excellent goal – and it is theoretically possible. The issue is I do not think we are on track at this moment to achieve it.

And let me just highlight three areas of missed opportunity I see today, which drives the scepticism that we are on track for net zero by 2050. The first is disappointing fuel-efficiency gains – especially as it relates to oil demand; the second would be nuclear; and the third would be methane and natural gas. And if it is OK, Alex, maybe I can address each of those very quickly to go through some of that.

If you look at fuel efficiency as it impacts oil demand, we are way off-track from what are called ‘CAFÉ’ standards here in the US – so ‘corporate average fuel economy’ – which in a nutshell is your government required miles per gallon, as we would say here in the US, improvement in vehicles.

Improving fuel efficiency drives almost all of the heavy lifting in terms of these peak demand forecasts that you see from either the IEA’s Net Zero report or BP or any other high-profile forecasters – the heavy lifting on will oil demand peak soon comes from fuel efficiency. But we are missing those targets – the world is missing those targets, and the US and China specifically are missing those targets, by 70 to 95%.

The actual compound annual growth rate in miles per gallon is 0.4% over the last 10 and 20 years. The government is mandating 3% to 4% improvement in fuel economy – and most people take the government mandates as ‘the given’ when they forecast peak oil demand. Yet any analyst can do these numbers and we are missing those government mandates by almost the entire amount.

And that is because, especially here in the US, people are shifting from cars to SUVs. There has been a huge mix shift and the increasing weight of those SUVs – even though an SUV today is more fuel-efficient than one 20 or 30 years ago – essentially goes to offsetting almost all of the government-mandated fuel economy gains. There is a difference between real-world driving; there is the fact that cars you trade in do not die, someone else just buys them and they continue to be on the road – and, by the way, at a diminishing fuel efficiency over time would be my guess.

So that is a big, big miss. It makes us entirely dependent on the electric vehicle ramp. Now, no-one ever believes this but I am a passionate believer in electric vehicles. I have had the good fortune to have driven a Tesla for the last six years and I personally will never drive – as my own car – Ice (internal combustion engine) vehicle again. I love driving an electric vehicle – but I am also very lucky to be someone who worked on Wall Street and had the type of job that allowed them to afford an EV. And I think the timeframe to turning over the ICE vehicle fleet is measured in multiple decades. It is not measured in five years.

The second one I want to address is nuclear. I am not a nuclear expert. As I mentioned in my background, it is mostly the upstream oil and gas space and some of the related renewable sectors – so that is my area of expertise. But, as an energy expert, it is really hard to understand why you would prematurely close plants that are in existence today, whose lives could be safely extended – and maybe that is the catch word – but I will say safely extended, especially in California, New York and Germany, which come to mind, and at a time when we have not addressed the intermittency issues that exist in renewables. You all are based in the UK and you can clearly see it there.

I want to make it very clear – we need to shift to cleaner, less carbon-intensive forms of energy but, until you have more robust battery storage and other back-up sources, why would you close the cleanest form of energy you have today – nuclear? I do not understand that.

The third area is natural gas and here I am going to put the blame squarely on the oil industry for not being more proactive in finding an industry-wide solution to methane. And methane would be the reason why, perhaps, natural gas does not deserve to be considered a transition fuel from coal to natural gas on our way to renewables. It should be an energy transition fuel. The rest of the world – in particular, China and India, which have massive coal resources – should transition to natural gas.

But if industry does not proactively deal with methane – and today we have the technology and the ability to address it at a pretty low cost, relative to what might have been the case five or 10 years ago – I blame industry for having it called into question as to whether natural gas is a transition fuel.

So my point would be, when we are not doing the easy stuff, or the stuff that is doable today ... miles per gallon: no-one, or very few people, have to drive an SUV. You can definitely clean up CAFE regulation. Nuclear: maybe you do not want to build new plants – I disagree with that, but maybe you do not – but what about the existing plants? Why would you shut them down? It makes no sense. And then not flaring your methane to ensure natural gas is a viable transition – you are going to have to do all these things, if you want to say you are on the path to net zero by 2050. So we should be on that path but I would say, unfortunately, I do not think we are.

JTR: I mentioned on a previous podcast, with Erik Kobayashi-Solomon, a Tweet I came across some time ago. It was a bit of a joke but, as is often the case, there is a little bit of truth behind it. And it was saying something along the lines of, if it was not for the people protesting against nuclear in the 1970s, the world would not be in the position it is today – it would be a bit cleaner. And there are very polarising positions when it comes to climate change at the moment and even some states in the US, especially in the West Coast, want nothing to do with gas at the moment. They are even fighting to stop gas being used in buildings for heating. My point is those very strict positions when you do not have any other alternative only seem to make things worse in the medium to long term, rather than short term. Would you agree with that?

AM: There is absolutely no question that every single person on earth will absolutely take electricity and gasoline or whatever form of energy to power and heat their homes or businesses and for transportation that they can get today. As my colleague Jason Bordoff at Columbia mentioned in a recent op ed, when the Colonial gasoline pipeline in the US went down, the only question was, how quickly can you get it back up online?

There is no debate about, hey, is not it good we are not selling gasoline to the East Coasts – that will force those crazy New Yorkers to buy a bunch of electric. There is no talk about that. It is impractical. Every single person on earth, with the possible exception of a tiny minority of environmental extremists, will absolutely take electricity, power and transportation fuels.

So when you start saying, I am morally opposed to this or that, you darn well better ensure that what you are proposing can meet requirements. I think there is a big risk today that when you prematurely transition away from stuff that everyone uses to stuff that does not always work, you are at risk. And again, that is not to say we should not be pushing towards renewables – we should. But you are going to need battery storage to become much more economical so that when the wind is blowing very hard, and when the sun is shining especially bright, we can store those molecules and use it when the sun is not shining and the wind is not blowing.

And if you do not have that today – if you do not have adequate storage capacity, which we obviously do not – how can you talk about not wanting natural gas on some purity-type objection? That is fine, if you are an elite – if you are part of the 1%, or perhaps even the 5%. That is fine to have those views, if you are an environmental extremist – you are certainly entitled to them. But what about everybody else?

What about the billions of people in Africa, India, China and Asia? And even in the US and perhaps in the UK and Europe, who are energy-poor today? Or maybe have ‘energy-nothing’? How many daily active users does Facebook have? Do they have one or two billion? So there are 7.8 billion people on earth and, sadly, daily active users for energy is only around 5.8 or 6 billion. There is potentially as much as two billion people who burn bad biomass in their homes to heat it. Yet, we are going to take some purity pledge not to use natural gas? Or be upset that this nuclear plant might theoretically have some problems?

What about the billions of people? And there is absolutely a responsibility on the part of elites – on the part of the 1% and the 5% and on the part of environmental extremists – to not leave people behind. That is absolutely immoral. And you can talk about change and you can talk about warming – those are all very serious issues. So the counter to the oil industry is: you cannot just talk about reducing energy poverty – you have to eliminate flaring, you have to eliminate methane leaks, you have to be part of the solution as well.

JTR: That is a great segue into my next question. Traditional energy companies have been vilified for causing the current state of affairs. They are ‘enemy number one’ – but they are not going away anytime soon and nobody knows more about hydrocarbons than they do. So what role should these companies play in the whole debate around addressing climate change?

AM: People generally do not like traditional big oil companies, right? I mean, no consumers is like, I love the gas station I go to. Sure, they are happy it is there – they definitely would not want it not to be there – but no-one says, man, I really love BP or Exxon, this is such a great gas station. No-one says that, right?

Investors love to hate them too. Go on Twitter and look at energy – for example, #EFT – it is nothing but pure hatred for the sector they are otherwise invested in and cover. It is just because the profitability is not great but there is this consensus not to like traditional oil and gas, even though you critically need it.

And I do not know why people want to rope these companies in and force them to invest in future technologies they do not know anything about. There is no shortage of capital on Wall Street for electric vehicles. You do not need oil companies doing any of this stuff. When it comes to hydrogen, wind, solar, there are so many companies out there – in the US and Europe and China and other parts of Asia – there are investors funding this stuff. There is absolutely no shortage of capital.

This mantra that every big oil has to become an energy transition leader – it is absurd. They have one overwhelming responsibility and that is to provide whatever oil and gas is demanded during the period we are transitioning, for however long we end up transitioning, to produce that at as low a cost of supply as possible, and hopefully for the benefits of their shareholders at a profitable cost of supply. That is their only goal.

Their number two goal – as far as it relates to climate – is to clean up what they are responsible for. There is no question oil and gas companies are directly responsible for methane that they flare into the atmosphere and for leaks that come out of the pipelines in other areas. It used to be hard to detect this stuff but, thanks to drones and other technologies, you can detect it much easier.

I actually think flaring is getting to the point where it is inexcusable. We used to dump chemicals into rivers in the 1970s and then society said, you know what, this is not such a great thing, let’s not do that anymore and let’s clean it up. We need the equivalent of that for methane. Individual companies, to their credit, are promising to do that but you really need an industry solution – either industry wide or in various basins or areas of operation.

So clean up what you are responsible for – but asking an oil company to deal with consumer choice? It is absurd. How is an oil company responsible for the limitless Amazon delivery trucks, endlessly circling all of our neighbourhoods? What oil company has anything to do with that? What oil company can impact even a single ICE vehicle in the global carpark? What oil company can force any consumer not to buy an SUV?

And so this ‘Scope 3’ insanity of, let’s hold oil companies responsible for what either consumers do not want to deal with on the road or governments do not have the guts or the strength to enact via their own policies ... Again, look at CAFÉ – how significantly it is missed. In the US, that is a bipartisan effort – you cannot blame Democrats, you cannot blame Republicans. So both parties in the US and, I would argue, in authoritarian regimes, for example in China, and other parts of the world, wherever you are – there is a huge miss on fuel efficiency, none or very little of which has anything to do with any major oil company.

They should be responsible for producing whatever oil and gas at as low a cost as supply – I am an investor person so I would also say as profitably as possible – that is the role. And if it turns out that oil demand is declining in the future then, as an investor, you are going to say, I do not want you growing your supply. Maybe I want you to turn into a yield vehicle with dividends or stock buybacks. Maybe the goal is to gobble up other companies who are exiting the business. Consumer demand is going to determine the fate of oil companies – not ESG investors, not government hatred towards oil companies. Again, no one likes their local gas station but you critically need it.

AlM: We are seeing some of the energy majors, particularly on the European side of the Atlantic, starting to invest significantly in renewable projects such as hydrogen but it sounds like if you were the captain of those ships, you would be advising against that. Would you, however, be advising an oil company today to be investing in something like carbon capture and sequestration to prolong their of ability, not only to provide this resource profitably but also as regulation starts to kick in? Carbon prices are rising so, if you were the CEO of a major oil and gas company, what technologies would you be advising them to invest in? Or is it simply a case of running down these businesses?

AM: Thank you for asking that question because it does not offer me an opportunity to clarify my previous answer. I would not say there is no new technology any oil company should be investing in. Again, I think they have to prove first they are good at what they have historically done. And, as I mentioned earlier, for the last decade, profits in the traditional oil and gas space were poor.

So, if you invested poorly in the area you knew best, who are you to invest in some new technology – especially when there are a lot of excellent companies in those areas, who may or may not be profitable but at least are leaders? Tesla would be a good example here. It is clearly a leader in the electric vehicles space – perhaps not super-profitable, but a leader nonetheless.

I think there might be logical areas in these newer technologies for energy companies to invest in, I actually think carbon capture, use and storage (CCUS) and direct air capture are either areas traditional oil and gas companies are going to have to invest in, or they are going to have to incorporate one way or the other. I think it is unreasonable to say, Exxon, BP, Shell, Total, you are responsible for consumers driving their cars and burning CO2 into the atmosphere. That is absurd. That is the modern life we all live.

But I think you can say that, by some year and I do not know what year it is – I do not know if it is 2030, 2040 or 2050 – the barrels you produce or the MCF [million cubic feet] you produce should be carbon-free or net-zero. And I do think carbon capture and direct air capture are two opportunities by which, if your barrel or MCF has a certain CO2 characteristic or value associated with it, that value should be offset by carbon capture or storage.

Now, there is a whole bunch of issues today with the carbon offset market, which I think it is probably beyond the scope of either my expertise or this podcast. I am not suggesting companies should be let off the hook by promising to someone else they are not going to cut down some tree in theory. I am talking about true and actual and verifiable – and we are not there yet on any of this stuff. We are not there on the accounting, we are not there on the verify part, we are not there on cost as it relates to CCUS or direct capture. But I do think that is an area where, again, maybe it makes sense for some of them to invest in, or maybe it makes sense for them to partner with companies to get that benefit, and therefore they have to put in real investment dollars.

When I look at the European majors and how aggressively they are transitioning, I respect first of all that they are sincere in their efforts. I do not think at this point, they are doing it for publicity or to ‘greenwash’ as some would say – I think they are sincere in wanting to transition. I will say, as an American, my comfort level is much greater with what Chevron proposed at their recent analyst day, where it is a little bit of a go-slow approach over the next decade as the company looks at a number of technologies.

I do not want to misquote Chevron but I believe hydrogen, carbon capture and some of these technologies were part of that portfolio and they talked about renewable diesel and renewable natural gas. Those all strike me as logical, adjacent areas where you might be able to generate good profits and where there might be some basis to believe there is expertise. And I think that is a way – in a proactive sense, not just cleaning up your methane mess – that you can engage in energy transition, renewable diesel, renewable natural gas, carbon capture, direct air capture and possibly hydrogen.

I am personally less comfortable with the very aggressive transition strategies the European oils are taking but it is quite possible they will be proven right. They have all been great companies over, frankly, centuries. If you look at Shell, like Exxon, they were a great company in 1907, when Royal Dutch Petroleum merged with Shell Transport and Trading, and they remain a great company today. So who am I to cast aspersions on their more aggressive transition strategy?

JTR: The amount of free cashflow the oil majors generate tends to be very high so why have they been so slow in investing in some of the technologies you say they are going to be looking at in the future? Why are they not outsourcing to someone else that responsibility to come up with the technologies or it is doing it themselves just out of their scope?

AM: To go back to the beginning of our conversation, when the majors were 8% to 15% of the S&P 500 and equivalent for the FTSE and so forth, they were very free cash-generative and they had very good profitability. That has not been the case over the last decade. The free cashflow significantly diminished, they were not even covering their dividends in many cases and certainly Exxon went from having more cash than debt to having way more debt than cash or anything else. So there has not been a lot of free cashflow.

And where did that failure come from? It came from their traditional business – again, the first order of business is improve your core competency. Again, it is going to boil down to core competency and core expertise. When you think of newer technologies and when you think of the types of companies that succeed in them, is it really legacy companies that do this?

Who cracked the code on electric vehicles? Was it General Motors? Was it Toyota? And I will say this respectfully – was it BMW or Mercedes, two great German auto manufacturers, the greatest manufacturers in the history of auto manufacturing? No – it was Tesla. It was a new company with a different mindset. Tesla has its own issues. We are not here to debate the investment merits of Tesla – I am talking about just the actual vehicle. Let’s produce an electric vehicle that people actually want to buy – can you imagine that?

So why do we think old, legacy oil companies are going to be the leaders in new technologies? It is not credible from an investor perspective. And if you have a core competency or competitive edge ... so, if you have a refining business, as many of them do, there is a logic to renewable diesel. It is much better than the old biofuels you might remember from the 1990s that, frankly, seemed like an agricultural policy disguised as an energy security policy, and did nothing for energy security. It was actually bad for the environment though perhaps it helped some farmers around the world.

Renewable diesel is much more interesting. Now you have issues with feedstock sourcing and whether you can do that efficiently. But the actual end-product is certainly significantly cleaner than crude oil cracked diesel, as an example, and I think that is a logical area for oil companies to pursue. Hydrogen probably fits into that bucket as well. I am not a hydrogen expert – I am sure you can talk to others who are – but it possible that could be an area of investment.

But I think there is this mindset that majors have lots of cashflows and therefore all those cashflows should go towards helping quote-unquote society address its climate problem. There are two billion people who do not have anything as it relates to energy. Let’s help them. If you want to critique oil companies, how about a more proactive plan to make those that are energy-poor energy-richer than they are today? That would actually be a constructive thing you could do, if we are thinking of societal goals.

Clean up their mess – that is something you can do. But simply having cashflow? Frankly, I do not understand the connection to why that should be used for climate –there is plenty of cashflow. There is no shortage of investor capital chasing climate solutions. Why do we need seven oil companies to be part of that?

JTR: Going back to what you were saying about the European majors, why is it you are not so convinced about transitioning into renewables as part of their main business? Is it that renewables are just so different from what they do or because the return profile of renewables is completely different?

AM: The area I would be least excited about, as it relates to traditional oil and gas companies, would be transitioning to power generation and, specifically, renewables. I do not understand what the competitive advantage is in those markets. Power markets are very different than traditional oil and gas and transportation-oriented markets.

They are not utilities – they do not have that mindset. Producing power to citizens is a very different dynamic than, essentially, selling a raw material – crude oil and natural gas – to frankly a wholesaler, who then might refine it, who then might market it, who then might sell it. Oil companies today, as hopefully people appreciate, own very few of their actual gas stations – probably a little bit more in Europe; very few in the US; and, in other parts of the world, national oil companies make that statement hit-or-miss depending on where you are.

But it is a simply a different business. I mean, why don’t they just get into cloud storage? That seems like an exciting area. I am a beer drinker why don’t we get into the beer business? Why don’t they get into 5G? To me, that sounds more interesting than solar. I do not understand why, just because they produce oil and gas ... some of that makes them energy experts, broadly speaking, but it certainly does not make them power-generation experts. It is just an absurd mindset the world has today – this, we are going to force companies to do something they know nothing about. What?

AlM: Is that where hydrogen is maybe a bit different? We can electrify lots of our economy but electricity is not great at creating heat and to fully decarbonise some of those ‘difficult-to-evade’ heavy industries, such as steel and cement, we are going to need some form of combustion fuel – whether it be gas, whether it be synthetic fuels or whether, potentially, it be green hydrogen, That last market is still so small at the moment but is green or blue or whatever colour of hydrogen potentially where some of these energy companies do have a right to win and where they do have that existing infrastructure to be able to create a market and create another growth driver for their business that could lead to better returns, given the lack of competition in that space, versus renewables?

AM: I think that is right. I would agree that hydrogen is certainly an area worth investigating on the part of, especially, let’s call it integrated major oil companies, perhaps more so than a pure-play upstream exploration production company, which at least in the US is still a large portion of the market. It is less so in the rest of the world where they do tend to be integrated majors.

But again, with apologies to people who are actual hydrogen experts, it is pretty clear ‘grey’ hydrogen is – if I have my colours correct – probably not so great environmentally. I think with blue hydrogen, the question is going to be, critically, can you fully account for the methane flaring and leakage and other negative externalities? I think, if you can, then blue hydrogen has a chance.

But I would think that, if you are an integrated major, you do not have to be proponents of ‘blue is best’. And I think your comment that we are probably going to need green at some point, especially for difficult-to-evade sectors ... I would agree that is an area worthy of investment. There are probably still some questions as to whether private capital, venture capital and so forth is the better avenue but, certainly, I think it is credible for the majors at least to have some number of folks investing in these areas, for sure.

JTR: I would be interested to hear your opinion on the whole capital preservation argument to force the hand of many fossil fuel companies to make a transition. Will this have any meaningful impact or just make matters worse? And in line with that argument, do you believe it to be true that the cost of capital for these companies will rise as a whole?

AM: I find this to be the most absurd and dangerous line of thinking that exists today, that somehow, if you limit oil supply ...  frankly, only in some locations, apparently the accessible locations – you can go protest an oilsands facility or a pipeline delivering oil. So we are going to protest this pipeline and somehow this is going to make any difference to anyone, anywhere in the world, that is actually positive.

In the short term, if you protest an oil pipeline in the oil sands, it simply gets trucked or railed out of the oil sands and that, for sure, is worse environmentally. You have negatively impacted blue-collar jobs in Canada or in the US, and you simply shifted supply to most likely the Middle East or Russia. Now, again, I am an American so I apologise for that perspective that Canada is good and it is better than the Middle East and Russia. I absolutely believe that as an American and I apologise to your global listeners for that perspective.

But the point would be that, unlike electricity markets, oil supply is global. Stopping supply from a specific company or group of companies or a specific location is simply going to mean it will be produced somewhere else. So why not go protest the new Iranian export facility or go protest Nord Stream 2,  which I am going to guess no one will want to protest because you are going to want that natural gas in the UK, if I am not mistaken at this moment.

So energy security is a huge issue and this ‘let’s stop a handful of Western oil companies from developing their oil’ – I think it is completely irrelevant. You are going to have to deal with consumer choice. I have already mentioned the failure of CAFE. I have mentioned the preference for SUVs. So instead of banning ICE vehicles, how about banning SUVs? That is not going to be winning platform for a politician.

But, if you wanted to actually do something for the climate, how about either banning SUVs or – and maybe this is more sensible – a ‘gas guzzler’ tax, which I think someone talked about in the 1970s. For every mile per gallon below 30 miles per gallon that your car or SUV gets, it is an extra $10,000 or $50,000 or $100,000 to buy that vehicle. So we are not living in consumer choice – we are making you pay for your pollution, as a consumer, in voluntarily choosing a bigger car than you actually need to drive.

Restricting supply on just a handful of companies? It is just silly and absurd. And it is going to be negative for reducing energy poverty and it is going to be negative for geopolitical security – both of which we can already see, especially in Europe and China and California, today.

All of that, to repeat, is not to let oil companies off the hook – the mess they have created and are responsible for as it relates to methane, perhaps as it relates to orphan wells or some other areas that I think big companies are dealing with ... but you need mid and small sized. That is the other irony – the big companies are doing a lot of correct things. You actually need the broader industry. You need national oil companies and international oil companies – none of which, for whatever reason, attract the ire of especially Western environmentalists – you need them to get on board with this stuff.

If you clean that stuff up, you will put a dent – an actual dent – and it is achievable today, based on current technology and current estimated cost to clean up. Do. That. Stuff. And then figure out how you can change consumer behaviour away from inefficiency and ICE cars and towards something better.

Cost of capital has gone up already and it has gone up because the industry had poor profitability over the last decade. So it has gone up because traditional investors said, why am I going to waste my time in a sector with such inherent volatility and where profitability is not good? So I think cost of capital is already going up and when you now add in the uncertainty of when that oil demand curve rolls over, I personally think it is after 2030. Other people think it maybe already happened before the pandemic, or maybe might happen this decade. I am in the ‘somewhere after 2030 and probably after 2035’ camp.

But it is also not ‘never’. For a variety of reasons unrelated to climate, oil demand would have naturally started to level off – and, again, I think that is probably a discussion for another podcast. So there is some long-term good news in there. I am not sure it would decline sharply without stronger policy objectives but it certainly is on track to level off even in the absence of climate. All that negatively impacts on a company’s cost of capital and actually hurts reduction of energy poverty, affordability of energy, and energy security.

AiM: You mentioned Nord Stream 2 there and some of the supply disruption we are seeing around the world at the moment. Certainly, on my cycle-in today, there were people queuing up for miles outside petrol stations. Changing the supply picture, we are likely to have more extreme weather, there is pressure on oil and gas companies adding new supply and, as you say, who knows how quickly the demand side of things will go but it could be slower than turning off supply. Do you expect, going forward, we will see more energy price spikes and supply squeezes that will create volatility in these markets? And what could that mean for the broader transition?

AM: One of the things I try to do best is avoid specific price forecasts, now I am no longer the Goldman Sachs super-spike analyst! But I will answer your question, which is, if we are an environment where traditional investors are upset with oil companies for past poor profitability, and no one wants any of these guys drilling more wells, and you have these ESG and climate pressures, you are in for an environment where supply will not be as robust as it otherwise would be. And that does lead to periods of spiking prices.

Energy prices were historically very volatile. My friend Bob McNally wrote a great book called Crude Volatility, which goes through the history of this business and the long history of price spikes and cycles. That existed long before there were concerns over climate or ESG or any of these kinds of things and so that will continue. But an environment where you are, potentially, artificially restricting supply in areas that are, again, on the geopolitical right side of the line, you are certainly subjecting yourself to a bunch of risks that I do not think regular people want, nor should they have.

I do not think spiking energy prices is good for the environment. How is it good to turn back on a coal plant? How is that helpful? Again, why are you shutting down your nuclear plant if we are going to end up having to turn back on a coal plant? That cannot be a good trade. I do not think you have to be a diehard environmentalist to think that is a bad trade.

So dealing with price volatility, on the one hand, is going to be critical to ensuring we continue to transition because you can see the headlines already – and I actually think, ironically, they are unjustified – that we are going to blame the entirety of this on solar and wind. It for sure deserves some blame but it does not deserve the entirety of the blame, because they have a long history of volatility. And frankly, companies could be drilling more today. We could have had more supply if traditional investors or management teams had encouraged it – and maybe that is why you have a pricing error.

The final point I would just make is, often price volatility can be a driver for positive change. So – and maybe this is a positive note as we wind down here – if you look back at the Arab oil embargo years, it was very painful. I was a young kid at the time but I remember, in the US, waiting in gas lines with my mom and you would have ‘odd’ and ‘even’ licence plate days for when you were even allowed to fill up with gas. No-one wants to go back to that but what was the outcome? The 10 years after the Arab oil embargo is the only period in history where we actually had a dramatic improvement in fuel economy.

At the time, we got Japanese imports of vehicles to replace Ford’s and GM’s big legacy gas-guzzler cars. So there was something good that came out of that very painful period. We also shifted away from oil as a power-generation fuel. Now, I think we shifted away because of energy security as opposed to any other reason but, perhaps today, we will get a mixture of energy security and some climate reasons for shifting away.

So the world does benefit from the volatility – though, I promise you, no-one likes the volatility. Even investors do not like it. These things are too volatile, it is unsustainably high, obviously it is very painful for consumers – especially any middle or lower-income consumer. Politicians hate it because they get blamed for their bad policies – the blame is probably justified, but it makes them want to shy away from policies we probably need. On the other hand, it does motivate behavioural change and that is something that is needed today, if we want to address climate.

JTR: Arjun, we are coming to an end to our recession and we have one final question – but split in two. The first part is, if you could persuade every investor to add one extra step into their investment process, what would that be? And the second part is, if you were the CEO of an oil and gas major today, what three things would you do to secure the business for the future?

AM: Those are great questions. On the investor question, the most important thing I look at is understanding an industry’s long-term profitability cycles. For me, that is return on capital, perhaps a free cash generation element to it and, most importantly, when are we at major inflections? Again, if you look at the traditional oil and gas business, from 1991 to 2006, we had a major uptrend in industry profitability and I would note, for the first decade of that – 1991 to 2000 – oil was stagnant between $15 and $20 a barrel.

It was restructuring and self-improvement that drove a dramatic improvement in profitability. So I would dissuade people from the notion that any bet on oil and gas is always a bet on high oil and gas prices. Year to year, there can be lots of volatility as oil and gas are up or down in that year but the structural trend is, frankly, ex commodity prices – and I would note that cycle peaked in 2006. So we started a supercycle that began in 2004, saw peak number one in 2008 and it continued until 2014 but the profitability cycle peaked in 2006 and at $70 oil – two years before we ultimately got to $147 in July of 2008.

And why did it peak? Frankly, companies started overinvesting in projects that required too high of a price and they got away from their core competency and that then resulted in a 15-year ‘down’ cycle, from 2006 to 2020. We thought the cycle bottomed in 2016 but we had the double-dip due to the pandemic. I think 2021 is the start of a new multi-year ‘up’ cycle in profitability for, especially, your top-quartile companies. Your best-in-class oil and gas companies have historically generated very competitive returns on capital, irrespective of what oil and gas prices do. And I would encourage investors to focus on those long-term cycles and, probably most importantly, resist ideology and groupthink narrative – and maybe I will leave that question at that.

Your second question was, if I was the CEO of an oil major, what things would I do to secure the business? First and foremost, you always have to fix the existing company. So, if at a given level of oil prices – and maybe that is $50 or $60 – you are not generating double-digit returns on capital, if in a modest price environment, you cannot generate competitive levels of profitability, you really do not have a reason to exist.

So what are the things you can do to restructure? That can be asset divestitures. It might be an acquisition –though it is harder to believe that investing capital is the path to better profitability – for a business that has not demonstrated in the past that its investments generated adequate profitability. If you did not do good in the past, why should I believe you are going to invest well in the future. So the first thing is, always, fix the company – and that is balance sheet and it is returns on capital more than anything.

The second thing is to understand what your core competencies and competitive advantages are – in anything. It is tough to use recent examples because I have some involvement with them but let’s just say you are a European oil and you do not have a good track record in shale, as an example. It can be logical, even if shale is an attractive business to some, for why it might not be attractive business to you. And so I am very sympathetic to people figuring out what they are good and bad at. But what are the areas you are good at? Right? And only in those areas should you invest.

I think the third thing is, where are the areas you are going to have to take a chance on? Because the good area today is never the good area tomorrow. Again, if I go back to the beginning of my career, you used to want to be conventional oil and gas – and, by the way, you used to not want to be an US oil company in the 1990s. Everyone knew you wanted to go to more complex projects in the rest of the world. At some point that shifted to deep water, then suddenly shale came around and first it was shale gas and then it was shale oil. And even with shale gas, it used to be the Barnett Shale in Texas and then it became Appalachia.

And so the areas of future goodness, or differential return opportunity, are always changing. And I think to both your questions – and maybe, Alex, you asked this more – does any of that seriatim of future good opportunity exists in clean energy? It absolutely does. I personally think there is a higher hurdle and more scepticism that should be attached to a traditional oil and gas company investing in those areas. But whether it is hydrogen, which we talked about, carbon capture, director capture ... perhaps that then fits on that bill.

I do think a lot of what are going to be attractive areas for an oil company are going to be in the traditional businesses – but guess what? It may not be that you should grow as fast as possible. Maybe your competitive advantage is you have a lot of good, long-life assets and turning into a yield vehicle can make sense. Maybe you should have more dividends and stock buybacks as a pure-play upstream producer, which historically was never the business model.

And so I think there is a lot of reason to rethink – what is the right strategy going forward? Historically, we have had population growth leads to energy-demand growth, leads to oil and gas demand growth – and it has been a very clear pattern that, in the last 150 years, we have never, ever broken away from. And the times that oil and gas has declined have always been a recession. It cannot possibly be a strategy to have a permanent recession. That is terrible. It is terrible for humanity to have permanent recession. No one should ever aspire to that or risk that happening.

But I do think, as an oil and gas company, it is prudent to ask, is there more risk that that linkage – at the end, energy demand growth means oil and gas demand growth – might break going forward and, if so, how do I think a little bit differently about things? It is going to slow even if you did not have climate – especially on the oil side. So those would be some of the things I would be looking at if I was ever to be the CEO of a company.

JTR: Arjun, thank you very much. That was fascinating.

AM: It is been a lot of fun. I appreciate all your questions and it is been a real pleasure to join you today. Thank you so much.

Author

Juan Torres Rodriguez

Juan Torres Rodriguez

Fund Manager, Equity Value

I joined Schroders in January 2017 as a member of the Global Value Investment team and manage Emerging Market Value. Prior to joining Schroders I worked for the Global Emerging Markets value and income funds at Pictet Asset Management with responsibility over different sectors, among those Consumer, Telecoms and Utilities. Before joining Pictet, I was a member of the Customs Solution Group at HOLT Credit Suisse.  

Alexander Monk

Alexander Monk

Portfolio Manager, Global Resource Equities

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