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The investment case for integrated oil companies

Fossil fuels are not dead.
Making fossil fuels cleaner might not be as sexy as a Tesla or as iconic as a windmill, but it has done much, much more to make the world cleaner. Photographer: Luke Sharrett/Bloomberg

Fossil fuels have been condemned as one of the largest contributors to global warming because of their emissions of carbon dioxide.

Despite this, the International Energy Agency (IEA) projects that the demand for coal, oil and natural gas will still outstrip cleaner energy sources such as nuclear and renewables by 2040.

Read: Eskom, Sasol emit over half of SA’s greenhouse gas

Ashley Lynn, head of fixed income at Orbis, has set out an argument for investment into integrated oil companies, mainly on the grounds that fossil fuels are not dead.

Speaking at the recent Allan Gray Investment Summit in Johannesburg Lynn said that when oil prices peaked at $110 per barrel in 2014, these companies were “fat and happy”. When the price slumped, things got really bad.

Two things changed

However, two things changed: the oil price bounced back to more sustainable levels, and the oil companies had to learn how to be more efficient and to do more with less.

In 2018 the oil price was around $72 per barrel, yet the companies did better on a cash flow basis. “They are just better companies, but they are still being treated as terrible companies in terms of their pricing,” she said.

According to Lynn integrated oil companies are at their cheapest levels in history relative to world markets. They are at a 60% discount right now relative to world markets on a price-to-book basis. On price-to-cash flow they are 50% cheaper than the rest of the market, and are giving about 2.3 times the dividend yield.

“So if fossil fuels are not going away, that really looks cheap … off-shore drillers are being priced as if the whole industry has gone extinct.”

A look at future demand

PwC said in its latest report on oil and gas trends that long-term forecasts still suggest that about 75% of global energy demand will be met by hydrocarbons (primarily coal, fuel oil or natural gas) well into the future.

In the IEA World Energy Outlook 2018, the projected change in the demand for coal will drop from 27% in 2017 to 22% in 2040, and oil from 32% to 28%), while gas will increase from 22% to 25%.

The demand for renewables will increase from 10% to 17% in the same period and the demand for nuclear will remain unchanged at 5%.

Lynn referred to the demand and potential growth of battery electric vehicles. She quoted figures indicating that 0.6% of all the world’s cars are battery electric vehicles. “In the US, the world’s largest consumer of oil and gas, there are 270 million registered cars and one million are electric.”

In South Africa there are fewer than 1 000 registered battery electric vehicles.

Read: Here’s how well electric cars are doing in South Africa

Lynn used data to show that the global reserves of copper, cobalt and nickel – three metals used in large quantities in electric vehicle batteries – will be exhausted by 2050 if the targets for the conversion to electric cars by progressive countries have been met.

The world will need 10 times the nuclear power plants we have today if we want to turn all the cars to electric and to source the energy from nuclear plants. The world’s uranium resources will be depleted in the next 10 years.

“Natural gas [a fossil fuel] has become so much cleaner over the years that replacing just one coal-fired plant with a natural gas plant gives you the same greenhouse savings as 99 000 electric cars,” she said.

The US has since 1970 managed to reduce its ambient air pollution by 73%. This happened while the vehicle miles travelled increased by a factor of three and the economy grew 253%.

Lynn noted that this did not happen because fossil fuels were reduced, but because their use became cleaner due to the introduction of catalytic converters, an improvement in the quality of fuels, and pollution control measures on refineries and power plants.

“Of course, making fossil fuels cleaner is not as sexy as a Tesla, it is not as iconic as a windmill, it does not look great in pictures – but the fact is that it has done much, much more to make the world cleaner than any of those things have,” Lynn said.

Orbis is convinced that fossil fuels are not dead. “Which is the same as saying when the herd is moving in the wrong direction, the best way to get ahead of them is to go back, to basics,” Lynn said.

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