The fossil fuels dilemma

Posted by Liz Rees in Latest insights category on 25 Jul 19

Oil & Gas is a large sector in the UK stock market and has been at the forefront of the global warming debate. Whether to embrace, or ditch, some of our biggest companies is a difficult decision for investors so here we weigh up the arguments for and against including fossil fuels in a portfolio.

Where are we today?

Coal powered Britain’s success as a leading manufacturing nation for many years. Today, of course, there is greater understanding of the destructive effect of fossil fuels on the environment and there has been a shift away from coal for electricity generation. In fact, all coal-powered plants in the UK will be closed by 2025.

Gas is now the main fuel used for the UK’s electricity (coal is less than 3%) and while it emits 50% less carbon, is far from ideal. However, this year the country will generate more electricity from zero carbon sources (wind, water, solar and nuclear) than fossil fuels for the first time.

The British government has set a target of zero net greenhouse gas emissions by 2050, but this comes at a cost, estimated by the Treasury at nearly £1trillion. A possible policy move would be a carbon tax to encourage consumers to adopt low carbon energy sources.

In general, European oil & gas companies are more advanced in adopting carbon reduction strategies while those in the US and Asia lag behind. For example, Exxon and Chevron, the US giants have largely shunned a move to green energy.

The case for and against fossil fuels

Like it or not, fossil fuels will continue to be a key source of energy until advances in technology reduce costs and allow us to better harness renewables. Their contribution to global economic growth has undoubtedly improved the living standards of many and China is using a growing amount of oil to meet the demands of its expanding middle class population.

Pessimists argue that hydrocarbon reserves will be useless if mining, processing and consuming them becomes impossible due to stricter regulations or prohibitive pollution taxes. This would leave vast ‘stranded assets’ which are uneconomic to extract. In the very long term, fossil fuels are not sustainable whereas renewables, if utilised effectively, could provide an infinite source of power.

It comes down to ethics

Many fund managers believe that engagement with management, and using their shareholder votes, is the best way to enforce change. Nevertheless, climate change activists are lobbying investors to avoid fossil fuel companies completely. Pressure group Global Witness contends the $5 trillion the industry is expected to spend on new oil and gas fields is incompatible with the Paris Climate Agreement’s goals.

Norway’s $1 trillion sovereign wealth fund, is planning to sell a lot of its coal and energy shares to reduce financial and environmental risk, despite oil being the source of the country’s riches. However, it will retain Shell and BP as it expects them to be among the leading investor in renewables.

Certainly, the issues are not clear cut. Renewable power generation comes with its own risks; using large batteries for storage requires mining of rare resources and has environmental concerns in production and disposal. Solar panels manufactured in China can involve hazardous conditions for workers, while offshore windfarms create ecological risks to ocean life and migrating birds.

The commercial argument

The oil majors have deep pockets to reinvent themselves for a sustainable future whereas younger renewables businesses investing in the technology of the future can come with higher risk.

The oil price is critical to profitability. BP and Royal Dutch Shell cut costs aggressively when the price slipped below $30 in 2016. Furthermore, the cost mining a barrel of oil has fallen significantly over the last 5 years so they make healthy margins at the current price of around $64.

The price is affected by supply factors, including actions of the powerful OPEC cartel, shale output in the US, and disruption due to political upheavals, such as Iran seizing tankers in the Straits of Hormuz. Despite considerable volatility, the price of Brent crude is actually down 42% over 5 years (FE data at 18/07/2019) and its future path is hard to predict.

BP or Royal Dutch Shell

Both companies acknowledge the problems facing their industry and are making strides to address them by investing in low carbon technologies.

Shell has been more proactive, setting targets to reduce emissions not just from its operations but from its customer’s activities too. This is an ambitious move, as E&P (exploration and production) accounts for only 15% of the company’s emissions while end usage makes up the rest.

The company plans to raise the proportion of lower carbon natural gas to oil, which is currently split 50:50. The takeover of BG Group (British Gas) made it the world’s largest provider of this cleaner burning and more easily transported fossil fuel. However, it will need to go further, including promoting electric vehicles, planting trees and improving its carbon capture capability.

Shell aims to be the world’s biggest electricity company by the 2030s, accounting for 30% of turnover. It has already invested heavily in electric cars and vehicle charging stations and from 2020 it will direct $4bn of its $30bn capex budget to new energy technologies. The International Energy Agency forecasts electricity to be the fastest growing segment of energy demand.

BP has agreed to enhance disclosure and monitor its own emissions but not those relating to users of its products. Predictably, it was the one targeted by climate-change protesters demanding stricter targets. Some of its biggest shareholders put pressure on it to produce a strategy in line with the Paris Climate Accord and the Board has recently agreed to this.

Both companies make appealing propositions for income funds. BP currently has a dividend yield of around 6% while Royal Dutch Shell offers a slightly lower yield of 5.7% but has a stronger balance sheet.

Investing in alternative energy

Renewable energy is becoming price competitive with fossil fuels, even when government subsidies are removed, which should see the investment universe grow. Opportunities range from established wind and solar power businesses to emerging technologies such as tidal, biomass and geothermal power.

Funds across the spectrum

The high yields available from BP and Royal Dutch Shell means they remain core holdings in many income funds. JOHCM UK Equity Income and Franklin UK Equity Income, silver rated by Morningstar, count both companies among their top 10 positions.

If you prefer to avoid the oil sector, bronze rated Standard Life Investments UK Ethical Equity specifically excludes fossil fuel exposure. For a more active strategy on renewables, bronze rated Impax Environmental may fit the bill.

In the investment trust universe, Renewables Infrastructure Group invests in long term wind and solar energy infrastructure projects while John Laing Environmental Assets invests in a broader range of environmental projects. Such specialist options should be regarded as higher risk.

Given the growing awareness of climate change, if oil companies are to flourish in a world less dependent on fossil fuels, they must adapt or die. Those which re-invest their substantial free cash flows into renewables are well placed; experience in managing offshore infrastructure under stringent environmental regulations gives them a competitive advantage.

Yet the transition is likely to be gradual. As the chairman of BP said: ‘It’s not a race to renewables, it’s a race to lower greenhouse gas emissions. As fast as renewables and clean energy can grow, faster than any fuel in history, the world is going to require oil and gas for some decades to come.’

Important Information: We do not give investment advice so you will need to decide if an investment is suitable for you. If you are unsure whether to invest, you should contact a financial advisor.