Why Have Some Investors Begun Betting On Oil?

Over the last few years, conventional energy stocks have been beaten down to extremely low levels over concerns about the entire space being a value trap for investors. By conventional measures of value, these stocks quote at higher-than-average dividend yields, and lower-than-average cash flow multiples, revenue multiples, and book value multiples.

The Nifty 50 has a dividend yield of around 1.2 per cent, whereas, stocks like Indian Oil, ONGC, and others, quote at upwards of 6 per cent.

Many wrote off the sector as major investors refused to buy these stocks, while others were concerned about the various headwinds the sector faces. Nevertheless, currently, investor interest in oil has risen along with the commodity’s price.

Significant Supply Constraints On Oil

Oil recently hit a seven-year high as demand outpaced supply, and the spare capacity for production is estimated to be quite thin at the moment. While Organisation of Petroleum Exporting Countries (OPEC) has been requested to scale up production quickly, it has been relatively slow to increase production. As a result, the price of oil has been bid up, with traders expecting the demand supply mismatch to continue.

Initially, United States’ shale oil had caused a market glut, the higher cost of production and other technical dynamics make the business unsustainable at low prices, resulting in lower investments in expansion. Around 100 oil companies in the US filed for bankruptcy during the Covid-19 pandemic, as the price of oil plummeted, making operations unsustainable.

“All the shareholders that I’ve talked to said that if anybody goes back to growth, they will punish those companies. I don’t think the world can rely much on U.S. shale,” Scott Sheffield, the CEO of Pioneer Natural Resources told Forbes.

Pioneer is the largest shale producer in the United States. With investors disillusioned about the prospects of Shale, operators had no option but to end expansion plans while returning cash to investors.

Regulatory measures such as heavy incentives to develop alternative energy sources, and the subsidies to develop the renewable ecosystem have caused investors to worry about the prospect of oil companies.

Across the world, governments have been pushing for adoption of electric vehicles as well. Oil and coal, in particular, are seen as unclean energy sources that would be phased out — putting constraints on the ability of such companies to grow further.

Several countries have mandated a certain part of the overall energy mix to be derived from renewable energy, while new coal projects are scrapped. India too, is in plans to stop the building of new coal-based power plants, and increase its reliance on renewable energy.

In addition, the focus on ESG has played a role in barring new investments in oil extraction as well. Several large investors and banks have decided to minimise investing in and lending to players in the non-renewable energy space. Large asset managers such as Blackrock and Vanguard, along with several large alternative asset managers have refused to invest in oil companies. The difficulty of financing new projects, further aggravated by regulatory issues, has played a role in preventing new projects from taking off.

However, despite the antagonistic attitude towards non-renewable sources of energy, they still remain a crucial part of the economy, and are likely to remain so for the coming years.

A revealing study by British Petroleum (BP) in 2020 found that even if countries were to aggressively reduce consumption and emissions by introducing regulations and incentives, the total investment required over the next 30 years could equal up to $20 trillion, just to sustain the demand in those years.

While BP has a conflict of interest in promoting the use of oil, even a fraction of the figure is quite massive. Just to reach the net zero goal, several trillions of dollars would be needed to be invested so that supply meets demand.

The study assumes that along with government support, there are no new projects built after 2020, except the ones already sanctioned. The investment required would encompass maintenance of existing sites, while completing sanctioned projects. In such a scenario, the price of oil is likely to go up as well, with supply being constrained, while demand decreases at a slower pace.

Oil and coal, however, are expected to have the highest negative impact. In contrast, natural gas, which is relatively eco-friendly, could see a lower impact as it could find greater adoption compared to oil and coal.

Investor Interest Returns With Expectations Of Higher Profits

Some chief executive officers of US-based oil companies believe that supply is likely to increase as prices now make operations sustainable.

For instance, ConocoPhillips’ CEO Ryan Lance believes that oil production is likely to surpass the 2019 highs, while others believe that output is not likely to reach the previous peak any time soon.

The world recently saw the effect of discarding the use of non-renewable resources too quickly. An energy crunch could possibly be more intense next time if supply of capital to the non-renewable fuel industry is continually lowered, leading to underinvestment in the sector.

Investors, however, are upbeat on oil stocks as they have remained relatively unharmed in the sell-offs in the global market. In India, Reliance Industries expects bumper profits from sales of natural gas, as the world battles with a gas shortage.

Some investors believe that non-ESG themes are oversold, while ESG themes are overbought, resulting in a decision to buy non-renewable stocks. According to some reports, large players have even short-sold some highly valued companies in the green energy space. Whether the shift away from growth into value is sustainable, or just a false start, is yet to be determined.

Nevertheless, the entire episode offers insights into market behaviour, extrapolation, and the effect of an artificial cap on capital flows.