Why the Future Still Means Fossil Fuels, for Now

by Fred Fromm and Matthew Adams, Franklin Equity Group, Franklin Templeton

Despite some news reports that suggest the green ambitions of the US Democratic Party could spell doom and gloom for traditional oil and gas companies, Franklin Equity Group’s Fred Fromm and Matt Adams see signs that increased demand for fossil fuels in select developing countries could offset any potential demand slump in developed countries such as the United States. They also explain why they think equity investors concerned about the potential for higher inflation might want to consider natural resources stocks.

Now that the 2020 US election results are fully known, and Democrats have control of the White House and both chambers of Congress, many equity investors have asked us for our views on the implications for the natural resources sector. That’s an understandable concern, considering the plethora of news headlines on how the so-called “blue wave” will likely lead to a series of environmental and regulatory headwinds for oil and gas companies. In particular, environmentalists have long encouraged the US and European governments to lower fossil fuel consumption, make vigorous reductions in carbon emissions and transition to energy sources compatible with the 2015 Paris Agreement on climate change.

Additionally, systemically important banks, the world’s largest insurers, the biggest pension funds and many top asset managers are calling for the disclosure of climate-related financial risks, and face pressure to divest their holdings in fossil fuel companies altogether. All companies have a stake in calculating the risks of their activities, and energy companies were already reviewing their oil and gas reserves due to pandemic-induced price declines in consumer end-markets, but this is no longer the sole consideration.

With the pandemic undermining economies and reducing energy use, what had been an abstract debate about leaving oil, natural gas and coal in the ground to combat pollution and climate change has become a legitimate concern for investors as politicians push for green spending plans. From global energy conglomerates to regional oil drillers, energy sector companies are looking closer at projects that are no longer viable. Some are even limiting their exploration-related investments, potentially leaving energy deposits worth billions of dollars in the ground. Exploration cuts happen for several reasons—some prospects may become unviable because they are too expensive, remote or technically challenging. Still, pressure from environmentalists seeking a low-carbon world has grown into a major influence and may lead to reduced supplies.

In our view, a Democrat-led US Congress could push Biden’s administration to introduce more punitive measures that have an immediate, but limited impact on the bottom line of companies in the exploration and production, oilfield services, and integrated oil and gas industries. Some potential examples include firmer federal restrictions on drilling, water use and carbon emissions from natural gas flaring, as well as the lifting of sanctions on Iran that could pressure oil prices. In addition, Democratic “Green New Deal” policies that grant subsidies for renewable energy sources, such as solar and wind, could accelerate a shift toward electric vehicles, negatively impacting demand, prices, and producer cash flows.

That said, we do not agree with some of the more dramatic headlines that suggest Democratic green-plan policies will lead to peak oil, or that oil demand will plateau and possibly begin to shrink in the next few years. In our view, demand for both oil and natural gas is likely to grow moderately over the next 10 years as consumption growth in developing countries more than offsets moderate declines in more developed nations.

We also believe that oil consumption will begin to bounce back as the COVID-19 pandemic recedes. For example, oil demand in China—which was both the first major economy to close and re-open due to the pandemic—is stronger today than it was a year ago.

In addition, if we do see any new harsh restrictions on oil in the next four years, we think it would likely lead to an increase in the market share for natural gas, which can also benefit oil & gas producers. It should also be noted that any successful efforts to limit US oil production are likely to help support global oil prices, benefitting incumbent producers and those with global operations.

Though carbon-based and not listed as a true “clean” energy source, natural gas has long been described as the bridge fuel to a cleaner-energy future as the world weans itself off highly polluting coal and oil. We still believe natural gas will play this role over the next decade, and the transition to cleaner energy sources is likely to continue to take place gradually, albeit at a slightly faster pace than if Republicans had maintained control of Congress and the White House.

Although Biden’s administration could follow the lead of some progressive states in banning the sales of internal combustion engine (ICE) vehicles, these initiatives tend to be implemented over several years and can be very costly for consumers. For example, last September, California published an executive order that required all new vehicles to be zero-emission by 2035, a target most observers believe will be difficult to achieve. However, California’s governor is currently subject to a recall effort due, in large part, to his aggressive pandemic response, but also due to his progressive agenda, including a ban on ICE vehicles.

In the near term, as we look at the year ahead, we are cautiously optimistic that the worst of the economic impacts from the COVID-19 pandemic are behind us. Although vaccinations appear to be occurring at a slower pace than hoped and the human toll continues to be enormous, we see a path toward normalisation that should revive demand for many commodities, including oil and natural gas. Like governments around the world, the United States appears intent on providing the additional stimulus necessary to drive an economic recovery.

Meanwhile, the pandemic and collapse in some commodity prices, particularly in energy-related industries, have led to underinvestment that will likely impact long-term supply. And though inflation and interest rates remain subdued today, underinvestment combined with robust stimulus spending may change that narrative and drive more significant interest in the natural resources sector. We have already begun to observe this trend and, looking forward, we believe more investors may look to hedge some of that inflation risk by increasing their exposure to hard assets, such as commodities.

In addition to traditional natural resources sectors, we have also increasingly focused on energy transition themes such as renewables and biofuels. As we mentioned above, it is widely expected that the incoming Biden administration will heavily promote renewable energy sources such as solar and wind, along with alternative transportation fuels derived from food waste and seed oils. Most related equities have performed very well of late, including those owned in our portfolios, and valuations generally appear stretched in our view. However, these sectors’ long-term growth potential appears robust and we are therefore looking for opportunities to increase exposure.

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