September 16, 2023

Ding DONG: New Energy Growing Pains Rewards Transition Patience

Despite significant volume growth and policy support, a trio of new energy indices—ICLN, NEX, and TAN—have now effectively gone nowhere since 2010 (Exhibit 1). You can pick different starting dates if you wish, but it does not change the lack of sustained shareholder value creation among the publicly-traded equities over an extended period of time. It is true that traditional energy, as represented by the XLE, performed poorly last decade. Despite those struggles, it has now outperformed new energy indices over the long run and has perked up versus the broader market as well.

Exhibit 1: Indexed performance of XLE (old energy) vs ICLN, NEX, and TAN (new energy), excluding dividends

Source: Bloomberg

There is also an established track record going back 100 years of the traditional sector alternating between a good 10-15 years and a bad 10-15 years. 2006-2020 was a bad stretch. As we have extensively documented previously, we believe 2021 marked the start of a good decade-plus ahead. There is no such history, at least not yet, of whether the same will hold true for new energy equities. The bet on new energy is still one of hope that technology and business models will scale at a cost structure where competitive profitability is possible without excessive subsidies.

The similarities between shale and renewables are often under-appreciated. Both sectors sought massive growth in a zero interest rate environment. The "growth without returns" strategy blew up for shale first; it's now happening in a variety of new energy areas, most recently with offshore wind generation. Importantly, humbled shale management teams have regrouped, with a welcomed focus on optimizing for profitability, free cash flow, and shareholder distributions, without any emphasis on what is now negligible volume growth. For the traditional sector overall, we have a very positive outlook for profitability and shareholder distributions in the 2020s versus the 2010s.

We are admittedly newer to renewables equities and do not have a history of in-depth financial modeling of those companies as we do with traditional energy. That said, we do have a history of covering high fixed cost, low variable cost businesses. When a bull market ends, such assets often trade at sharp discounts to replacement cost value. Whether that would be appropriate for the current batch of renewables equities, we leave to the current crop of Wall Street professionals. The different nature of power generation versus oil and gas production suggests a different path of restructuring and business model improvement will occur. We will also leave the ideas on how to do that to those with greater power market experience than we have.

As long-time Super-Spiked readers will already know, we have strongly disagreed with the idea that Big (or Medium or Small) Oil should feel compelled to urgently invest in so-called energy transition businesses. Frankly, cloud infrastructure or artificial intelligence look more interesting than renewables if one is looking to randomly invest in new business lines they know nothing about. Instead, we have argued the world is best served by the vast majority of oil and gas companies, especially those based in the United States, Canada, and Western Europe, profitably producing oil and gas for as long as the world still demands it, which we believe is going to be for a very long time to come.

We should be clear that this post is not intended as an "I told you so, the new stuff stinks." It seriously isn't. The challenges that many publicly-traded equities are facing in a higher interest rate environment is perhaps not surprising. In fact, the new energies opportunity set is quite diverse across a spectrum of technologies, geographies, end markets, stage of development, capital intensity, and ownership structure (publicly traded versus privately owned, etc.) Moreover, the scale and breadth of the effort being made with new energies needs to be taken seriously, even if some early business plans and strategies do not work and many heavy-handed, big government policies being pursued in Western Europe, Canada, and the United States are some mixture of misguided, counter-productive, or simply ridiculous. The fact is we are in a world where trillions of dollars are being spent in an attempt to crack the code on next generation energy sources and technologies. Some things will work even if many do not. Moreover, it is in the overwhelming interests of the four members of the 1.4 Billion People Club to find alternatives to imported crude oil and liquefied natural gas (LNG) in order to meet massive future energy needs. The scale of their energy needs points to there being little doubt that an "all of the above" energy strategy will dominate.

As for the current environmental and climate responsibilities for traditional energy, there is a need to eliminate Scope 1 and methane emissions and contribute to finding a solution to the blight that is orphan wells. In our view, that is what they are responsible for. Full stop. However, given the significant growth that will ultimately occur in new energy sources and technologies, we support companies evaluating logical adjacencies and generally studying new areas to see if a future opportunity materializes. But there should be absolutely zero urgency for traditional oil and gas to have to invest in new energies. In fact, we believe American and Canadian oil and gas companies are especially well-positioned to help meet the substantial energy demand growth potential that exists among the 1.4 Billion People Club, which will need a lot of all forms of energy in coming decades. The world is a healthier and safer place with viable and profitable oil and gas companies in America and Canada (and ideally Europe as well).

The energy transition poster child: DONG to Orsted

Danish Oil and Natural Gas (Danske Olie og Naturgas A/S), better known as DONG Energy, has been heralded by those most passionate about addressing climate change as an example of a company that successfully transitioned from its oil & gas roots to Orsted, a heretofore energy transition darling primarily focused on wind generation. In recent years we have repeatedly heard policy makers, academics, and ESG investors question why oil and gas companies, especially the Super Majors, are not transitioning faster toward the new stuff and away from oil and gas.

The collapse in Orsted shares and the broader decline in clean energy equities is a reminder that investing in energy is never easy (Exhibit 2). The old stuff is hard. The new stuff is hard.

Exhibit 2: Orsted market capitalization has round tripped

Source: Bloomberg

Frankly, there is more common ground in terms of the drivers than is often appreciated.

  • Traditional energy investors have long been cautious when companies seek capital intensive growth; some have thought that new energies would be immune from similar risks of cost over-runs and delays. It isn't.
  • Dependence on "zero interest rate" financing resulted in a massive overcapitalization of US shale last decade. Clean energy has not only been turbo-charged by that same low-rate environment, but also massive fiscal support from US and European governments. This suggests an even higher risk of clean energy overcapitalization. The growing pains have arrived.
  • When governments are driving the growth charge, be wary. This is true in old energy and looks to be true in new energy. We note that there is a distinction between driving the growth charge versus establishing incentives, rules and regulations, the latter of which is of course needed for all forms of investment. In old energy, we would contrast the Texas shale boom with repeated failures to grow oil production in Mexico or Argentina as examples of this point.
  • Significant commodity price volatility and cyclicality offers both opportunity and risk for traditional energy CAPEX. In the case of solar and wind projects, contract terms can vary and may or may not allow for recovery of cost over-runs or provide the opportunity and risk to volatile power prices.
  • We strongly disagree with the idea that oil and gas deserves an ESG discount and new energies warrants an ESG premium. We suspect it will take a multi-year period of favorable traditional energy profitability coupled with an extended downturn in new energies to alter this dynamic. The broader topic of ESG reform is for another post.

Counter-cyclical investing should hold in new energies

The significant risks that come with investing in high fixed cost, low variable cost businesses, especially during the growth phase, is something traditional energy investors have long known. There is not a for-profit company on Earth that does not believe its capital spending will generate competitive returns. Very few investments have been made with the perspective: "Yeah, we know the profitability will be mediocre, but we're going to go for it anyways!" Clean energy investors appear to be learning lessons that traditional investors have learned many times before.

With all that said, we see no reason to believe that new energies won't go through similar bouts of excessive pessimism after a period of over-optimism as we see with traditional energy. Investing during periods of pessimism is almost certainly the more interesting entry point. Veteran solar sector investors already know this.

In order to meet the substantial energy needs of the 1.4 Billion People Club, we will need all forms of energy, both old and new. Off a low base, the new stuff is likely to grow significantly faster than oil and gas, notwithstanding the current correction phase it is going through. When the world is spending trillions of dollars trying to crack the code on future energy sources that will provide abundant, low-cost energy, it would seem inevitable that something will work. Companies exposed to whatever that new area is will be rewarded. The best recent example is Tesla, which cracked the code on penetrating the luxury vehicle market and is now a near trillion-dollar (market capitalization) company. Everyone is understandably looking for the next Tesla. With all that said, the promise of fast growth does not excuse the risk of disappointing profitability when there is inflation, cost over-runs, or other execution issues.

As a firm, Veriten spends considerable time evaluating a broad range of new energy opportunities. No one should ever confuse our pragmatism with pessimism about the potential of new energy. We simply do not subscribe to the religious aspects of the climate change movement and the idea that all energy companies must transition to the new areas within some preposterously short time frame (e.g., <30 years). Green versus brown, clean versus dirty, etc., are not actual energy attributes. They are, at best, misleading marketing labels. Cost of supply, CAPEX per unit, operating cost per unit, margins, utilization rate, carbon/methane intensity, NOX/SOX emissions, and environmental footprint are all energy source attributes.

Remembering Tosco: Buying assets at pennies on the dollar

For high fixed cost, low variable cost businesses like refining, drilling rigs, and supply vessels, we used to analyze where companies traded versus replacement cost value (RCV). This is from memory, but historically purchasing companies when trading at large discounts to RCV (50%-90%) was a starting point. Once a company approached or traded through 100% of RCV, caution was often warranted. This is an analytical framework we need to update for a range of energy sectors. It would be interesting to do this for power plants of all flavors.

To make a long story short, an alternative strategy to growth CAPEX is to wait for that growth CAPEX to blow up and purchase the assets at a discount. In the mid-1990s, US refining company Tosco under the leadership of legendary CEO Tom O'Malley, pioneered the strategy of buying refineries for pennies on the dollar, cutting costs, optimizing the asset, and ultimately generating far better returns on capital than existed with greenfield expansion. Tom O'Malley will be an original member of a future Energy CEO Hall of Fame (for a future post).

We need to do more work on the various renewables opportunities to see when it could become interesting based on a severely discounted valuation versus RCV or a similar concept more appropriate to this sector. But the idea that oil and gas companies should participate in the high CAPEX growth stage of these kinds of industries is an area where we agree with shareholders on demanding extreme caution. We also recognize that with many emerging areas, it is quite possible there is no value in a technology or opportunity that is not able to scale at cost without meaningful subsidies, making a “deep value” approach irrelevant.

To be clear on a few points:

  • There is no guarantee that a high fixed cost, low variable cost business will earn its cost of capital on greenfield expansion; however, when it is in short supply relative to demand, returns will need to be high enough to motivate CAPEX.
  • When high fixed cost, low variable cost businesses are in structural over-supply, companies are likely to trade at sharp discounts to RCV for as long as the oversupply persists. In essence, returns normalize to a lower level based on variable costs and maintenance CAPEX.
  • Capital investment can become "stranded" if undermined by lower cost technologies. However, when an asset has near zero variable cost, it would seem like its existence is ensured even if original investors are wiped out.
  • We acknowledge that there is no certainty a “value investing” approach can be applied to new energies.

⚡️ On a Personal Note: Concert Corrections and Clarifications

Well, our Top 10 concert list drew many more comments than we expected and actually about as many as did the core of the post about the 1.4 Billion People Club. Incredibly, we will have to issue what I believe is our first ever Super-Spiked correction, courtesy of a refining industry metalhead.

Ozzy and Metallica Erratum #1. Cliff Burton died on September 27, 1986. I saw Cliff perform with Metallica on April 21, 1986 at Brendan Byrne as Ozzy’s warm-up act. It was (I believe) the December 1, 1986 Metallica show at the Felt Forum (as it was then called…the theatre under MSG) that was the concert I attended shortly after he passed.

Ozzy and Metallica Erratum #2. Similarly, James Hetfield broke his arm on July 26, 1986, while skateboarding before a show in Evanston, Illinois, but well after the Brendan Byrne concert I attended. I remembered the arm breaking correctly, but not the timing.

Rush. As most of you know, I am a huge believer in the importance of the Canadian oil and gas industry to help meet the world's energy needs. Hopefully my exclusion of my 11th favorite concert proves I am not trying to pander to my Canadian subscriber base. We are all about substance and analytics at Super-Spiked; not currying favor with the masses. I went with a hard cutoff at Top 10. Rush at Brendan Byrne in April 1986 was my 11th favorite show. I sat in the PSE&G box where my friend's father was an executive. I am a Rush fan, but not a die-hard; hence its omission from the Top 10. Neil Peart would make my list of all-time favorite drummers (my instrument growing up). And early Super-Spiked subscribers will remember we included Triumph, another Canadian hard rock trio, in our Super-Spiked Energy Transition Playlist. Since joining Veriten, we have not updated that list, but based on the concert Top 10 reactions, it may be something to resurrect.

Def Leppard. A Longhorn alum and oil and gas engineer I once worked with is one of the few die-hard Def Leppard fans I know (don't meet too many of them). My 12th favorite show was seeing the Hysteria tour in Buffalo, NY in February 1988 during my freshman (and only) year at Cornell University. To our knowledge, that was the original round stage where the band is surrounded by fans. Hopefully this memory is more accurate, but it was also the first tour after Def Leppard drummer, Rick Allen, lost an arm in a car crash. It was then revolutionary for a drummer to be able to play with one arm. In those days, the use of a drum machine would have been frowned upon by hard rock or metal fans. But the perseverance shown by a suddenly one-armed drummer changed hearts and minds about the acceptability of incorporating electronics into hard rock. Rick Allen was a DEI trailblazer of his era.

Non-Metal. In recent years, aside from The Dead, I have become a big fan of classic country. Johnny Cash, Waylon Jennings, David Allen Coe, Hank 2, and Hank 3. I don't believe any are still around anymore (maybe Hank 3 is) to still go see live. It is amazing how many perfect country and western songs there are about momma, and trains, and trucks, and prison, and getting drunk.