Fossil Fuel investments – who to blame for high energy prices ? (David Einhorn, Warren Buffett, ESG)
David Einhorn’s latest quarterly letter is clearly an expression of his frustration. However I wanted to pick out one passage that blames “ESG Investing” for being responsible for high energy prices:
So Einhorn blames both, his own under performance and the bad performance of energy stocks (and much more) mostly on the rise of ESG investing and politicians. He is not alone in his opinion that “ESG Investing” is the main culprit for the currently high energy prices.
First counter argument: Jim Chanos from 2013
As a first contradicting “Evidence” I would want to quote Jim Chanos from the year 2013 (!!):
Chanos said his Kynikos Associates fund was bearish on both national oil companies and the integrated majors.
“The costs of finding this stuff (oil) has gone through the roof,” Chanos said. “The economics are clearly deteriorating.”
“It isn’t the same cash flow generating business it used to be.”
Exxon Mobil and other oil producers like it continue to spend heavily not only to find new reserves but also to pay dividends and fund buyback programs, prompting concerns the companies have limited growth potential, Chanos said.
As recently as 2010, Exxon Mobil’s free cash flow, a measurement of cash flow minus capital spending, eclipsed the cost of share buybacks and dividend payouts. Yet executives have been buying back stock at a breakneck pace in recent years. In 2012 the company spent $30.97 billion on dividends and buybacks, with $21.9 billion in free cash flow.
So 8 years ago, when ESG investing was not existing, the Oil majors already preferred to buy back stocks and increase dividends instead of investing into new oilfields tata would create future growth. As a typical time horizon for new development of (offshore) is 8-15 years, cleary ESG investing alone cannot be the culprit.
What is the size of the “ESG Market” anyway ?
According to Bloomberg, ESG mandates could reach 1/3 of total AuM in 2025, the historic development can be seen in this chart:
At current ~150 trn total AuM, ESG mandates at them moment comprise 20% of the market, meaning that 80% of the market are “non ESG”. In 2014 this was more like 10%. If current fossil fuel upstream capacity is not enough, this is a result of decisions of 10-15 years ago when ESG investing played little to no role. It is a mirage to belive that the 20% of global assets that run under some ESG mandate now “force” everyone to stay away from energy projects.
Who or what is then to blame ? Maybe Warren Buffett ?
Provocatively one could say that it actually might be Warren Buffett’s responsibility. Ever since he bought See’s Candy in 1973, he kept reiterating that the best businesses need little capital to grow and have pricing power.
Now look at the typical oil company: It need boat loads of capital to grow and has absolutely no pricing power as it produces a commodity with an extremely volatile price.
In the last 10-15 years, even the hard core “Graham” Value Investors (with the exception of Mr. Einhorn) have joined the bandwagon of “Big Tech”. Most Value Investor portfolios look quite similar: Apple, Google, Facebook, Salesforce etc.,, maybe a few Visa or Mastercard positions on top and a legacy Berkshire holding. Even Mr. Buffett himself has made Apple his biggest public holding and not some natural resource company.
By coincidence, Microsoft, Google & Co. also have a relatively low CO2 foot print and that’s why the same stocks liked by “New Value” investors are also often the biggest positions in any ESG related fund. Here is a link to the biggest positions of the biggest ESG funds and, surpise, Alphabet and Microsoft are the top positions.
So to cut a long story short: In my opionion, ESG funds are not to blame for potential underinvestment in the oil and gas industry but the fact that the business model of most natural ressource companies is relatively unattractive compared to Microsoft &Co.
As many other declining businesses. many Oil & Gas companies preferred debt financed share buy backs and dividends in order to keep shareholders somehow happy instead of investing into the future. This is what Jim Chanos identified already in 2013, long before ESG investing had any impact at all.
The same applies also for instance to other capital intensive industries such as insurance.
A great example that capital is not scarce for Oil and Gas is clearly US fracking. Based on a new technology (Fracking) the big problem was that simply too much capital went into fracking leading to too much capacity and too low prices which bankrupted many of the over leveraged fracking players. At the peak of the boom, just a few years ago, actually the big Oil Majors started to buy fracking companies at Fantasy prices. Here is for instance a relatively recent article on how capital was destroyed in the fracking mania.
All of this came a little over a year after investors had begged the industry to stop taking on debt to produce oil that it sold for a loss. This resulted in promises from the industry to do just that and an analyst telling the Wall Street Journal, “Is this time going to be different? I think yes, a little bit.”
It wasn’t different, however, and the industry borrowed more money to produce more oil and gas — and lost more money doing it.
A 2020 report by Friends of the Earth, Public Citizen, and BailoutWatch estimates that the U.S. oil and gas business borrowed another $100 billion in 2020 while Bloomberg estimates over $62 billion in new losses for U.S. shale producers last year. These losses occurred despite U.S. oil production decreasing by approximately one million barrels per day in 2020 compared to 2019. Despite the pandemic, and prices for natural gas being the lowest in decades, U.S. natural gas production only declined 1 percent in 2020.
Let’s face it: Big Oil has an awful capital allocation track record in the past decade or even two and that is in my opinion one of the major reasons for low valuation. Not ESG and lack of access to capital , but destruction of capital at large scale.
Low interest /Discount rates vs. long term growth
This is going to be slightly nerdy but important. One of the big drivers of stock valuations in the past 25 years or so have been decreasing discount rates. All other things equal, a decreasing discount rate (driven by lower risk free rates) increases the value of any cash flow producing asset as its NPV goes up.
But now comes an interesting feature of DCF: The effect is higher for stocks with high long term growth rates because with high lower discount rates, profits in the distant future are much more valuable.
So let’s look an example of two companies who both produce a cashflow of 1 mn USD today and will grow for 3% for the next 10 years. However, company A will continue to grow at 3% in perpetuity whereas company B will not grow anymore (growth rate 0%).
These Cashflow profiles result at a discount rate of 10% an NPV of ~13,5 mn for company A and around 11,7 mn for company B. So the difference in the 3% more growth from year 11 onwards is worth around 2 mn.
Now let’s do the same calculation with a 6% discount rate. Suddenly company A is worth 31.3 mn USD and company B 20,2 mn USD. So that future growth suddenly is worth 11,1 mn vs 2 mn at the higher discount rate.
As the Oil and Gas industry had itself preferred to distribute cash instead of investing ionto future growth I think this DCF effect also explains a lot of the underperformance in the last decade or so, independent of any ESG funds. It’s just pure DCF, nothing else. As I have wirtten before: These companies are cheap for a reason (or two).
Short term vs. long term prospects and conscience
Of course, some Oil & Gas stocks might perform very well in the near future if enough investors are believing that these stocks are a great deal. However I do think that most of them are “fundamentally challenged” and personally I do think that Renewable Energy companies have the better future.
With regard to a “clean conscience”: I don’t think that even ESG investors should fully divest, rather the opposite: ESG investors should support these companies that are doing better than others with regard to CO2. Oil and Gas is needed for some time (and for chemicals for instance forever), so I do think investing into the industry either to press for change or support companies that are doing much better than competitors is a very valid strategy.
However what I don’t like are “phony”investors who for instance claim to be concerned about climate change but then collect dividends from a really dirty producer like Gazprom. This is something I could personally not do and still watch myself in the mirror every morning and with these kind of people I do not want to have any relationship.
Overall, I do not think that ESG investing has created a shortage of Oil and Gas. The industry has been simultanously underinvesting (Oil majors) and overinvesting (Fracking) and the Oil & Gas industry has a pretty ugly track record in capital allocation or rather shown all signs of large scale capital destruction.
On top, much more attractive business models came along and are competing for investor funds, making life harder for inefficient, capital intensive industries. And by coincidence these business models have much better climate footprints.
Therefore I do think that Divid Einhorn (and others) might want to look at their own investment process before blaming someone else for their misery. I still struggle to understand why such a smart person is acting so stupidly over the past 5 years or more. it’s jsut amazing how he basically killed off his public listed Greenlight Re vehicle and I am really glad that I got out without a loss a few years ago before things really got bad:
If you have the urge to submit Oil and Gas stock tipps: Please focus on these players who make the lowest emissions and have the most concrete plans for further reductions. Anything else is not interesting for me.