November 3, 2017

Energy, particularly speculation on the future of renewables and electric cars, is a hot topic of conversation at present, being as important to the cocktail party circuit as it is to the safe and smooth functioning of the global economy and our planet. Our society must navigate the turbulent waters between the environmental impact of our future energy supplies on one hand and the economics of new technologies which are desirable but uncompetitive on the other.

Kennox’s analysis on this topic has lead us to a substantial holding in the energy majors (16% at the end of September 2017). Why? In an industry that is core to the global economy, you can buy the leading blue chips at very reasonable prices, just when the cycle is turning favourable. Look through the near-term uncertainty, and the energy majors currently offer an appealing opportunity.

The future for energy will likely play out over three stages.

In the first stage, over the next ten years or so, oil will continue to be essential to the world, and to an investment case for an investment in energy. This is because the options are limited:

  • renewables are tiny still (5% of production), so even with spectacular growth, they still won’t touch the sides;
  • shale is huge, but it is not unlimited, and is still finding its feet as production and financing hiccups are ironed out;
  • gas is essential but isn’t making money currently; and
  • coal is still over 20% of global energy production, but is dead in the water (at least if we pay any attention to global warming).

Our energy needs and supplies will continue to evolve but it is impossible for the global economy to survive without oil within this time frame.

In the second stage, out further than this first decade, gas starts coming into its own. Electric vehicles will likely be dominating the global car fleet, but there just isn’t any other reliable and economic way of making enough electricity to power these new cars, other than gas. The energy majors saw this coming and made the investment in gas in the last ten years, positioning themselves ahead of time. It hasn’t paid off yet, but already there are positive signs – for instance, about 60% of US power generation under construction is gas.

In the last stage, say from 15 or 20 years from now, for the sake of our planet, we would hope that renewables are the bulk of our power supplies, as technologies are proven, rolled out, and achieve global scale. We would expect that the energy majors will be significant players at this stage: they have the skill set for large, complex and capital-intensive projects, whether offshore or onshore, and the financial heft to take substantial holdings. Already they are making strategic moves in the area, which will only increase as the technologies are proven and winners emerge.

The current prices of the majors are so attractive (c. 11x our view of their long term sustainable earnings) that we think an investment in this area is more than justified even over just the first, oil-dominated, period. This is because an investment in the majors is not reliant on the short-term price of oil: they are well positioned in gas, and vertically integrated with a variety of value-added products, but more importantly, they are the strongest players in the oil sector. They are driving down their costs so that they can generate cash and profits at much lower prices than in the past: Shell is making as much cashflow at $50 as it used to do when oil was at $90; BP expects to have a cost base of $35-$40 per barrel in the early 2020s. Do we wish for higher oil prices? No, we’d prefer the price to stay sub $60, as higher prices attract too much competition, pulling in more investment from smaller players and new entrants into the industry. Better for the prices to stay lower and have the sector leaders, the majors, make robust and sustainable returns.

It is always reassuring to have several tailwinds for an investment, and there is another one worth mentioning here. The energy majors have made huge investments recently, and now are set to reap the rewards as these investments come into operation. Shell for instance notes in their 2015 annual report that 30% of its capital employed was not generating any revenue. As this comes on stream, cash will flow with low investment needs. This is a very good time to invest – not when the oil price, and hence capex, is high.

The majors look very well positioned for the first two evolutions in the energy markets, and are likely to be significant players, if not dominant, in the third. We’ve taken a hard, analytical look at their current strengths and positioning, and what is possible and likely in the future. The investment case looks very good indeed.

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The Company is based in Scotland, UK with the above registered address (Registered Number: SC302037).

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