Moving back or doubling down?
Energy investing has changed over the past decade. How are LPs viewing their exposure to the sector?
Energy investing has changed significantly over the past decade, but as supply shortages have shocked the markets and governments scramble to address both climate change and energy security, how are LPs viewing their exposure to the sector?
As the COP26 climate change conference last year got into gear, a report entitled Invest-Divest 2021 showed that 1,485 institutions representing US$39.2 trillion of AUM had committed to some form of fossil fuel divestment to address climate change, remove the potential for being stuck with stranded assets and reduce volatility in their portfolios. Indeed, the report said that “fossil fuels have routinely underperformed the market” for the past nine years.
Of course, it’s a very different story today. The sanctions imposed on Russian oil & gas following its invasion of Ukraine have only exacerbated the energy price rises that came about as the world emerged from the pandemic. Oil & gas companies have made record profits in 2022, helping boost the returns made by investors that hadn’t divested. Indeed, Harvard University’s US$51 billion endowment, which lost 1.8% in the year to the end of June 2022, said some of these losses stemmed from its decision to divest fossil fuel-based investments. Narv Narvekar, chief executive of Harvard Management Corporation was recently quoted in the Financial Times as saying that some large investors had “leaned into the conventional energy sector” and that this had added “materially to their total return”.
Such dislocations are not unusual in the oil & gas sector, but with the drive towards cleaner sources of energy, how is the current situation affecting LP perspectives on where they should focus their energy exposures?
Ethan Levine, Head of Real Assets and Sustainability at Commonfund Capital, splits LPs into three main buckets. “You have one group of LPs that no longer invests in upstream oil & gas and they will never return,” he explains. “The second group have maintained their status quo: they have allocations to natural resources and are continuing as they have for the past 20-30 years. In the middle are LPs that are on the fence. They haven’t made commitments for the past five to seven years for a range of reasons, including ESG considerations, returns or stranded asset risk. I don’t know if they will come back, but it’s possible that they may be looking today at the benefits of portfolio diversification.”
LPs that have kept oil & gas in their energy exposures have seen a shift in the returns profile of these assets as the sector has increasingly focused on generating cash and moved away from growth strategies. “Conventional energy is now much more about cash flow generation and returning cash to equity holders,” Simon Oak, Principal, Lexington Partners. Or, as Shaia Hosseinzadeh, Founder and Managing Partner of OnyxPoint Global Management, says: “Investor aversion has transformed the sector into cash machines where you can put in a dollar today and expect to get it back from cashflow within three to four years.”
This, together with heightened concerns around energy scarcity, may be leading some LPs on the fence to go back in. “It’s too early to tell where capital will flow,” says Levine. “But I am hearing some people contextualise their ESG concerns in a new light. Energy security is important and it could be seen as sitting with the “S” in ESG. The EU is also signalling that gas is part of the transition mix.”
That said, it may be that investors considering the move are seeking exposure via other parts of their portfolio – if they do so at all. “I’ve not seen a broad-based swell of appetite for conventional energy, despite the geopolitical environment” says Niraj Agarwal, Head of Real Assets, State of New Jersey. “Although that clearly depends on the risk-return appetite of individual LPs. We are seeing investors increasingly separating private equity-style exposure from commodity bets and that’s presenting in short-term plays to take advantage of what’s happening with inflation and geopolitics. But long-term thinking isn’t shifting back towards private equity-backed fossil fuels.”
And while, as the Harvard endowment case illustrates, conventional energy can provide LPs with a hedge against inflation, this may well be short-lived. “Energy will continue to be a net gainer from inflation,” says Agarwal. “However, inflation will need to be managed. We are also likely to see slightly higher production so I’d expect spot prices to go down. Short-term this works, but there are bigger challenges over the longer term.”
Those longer term challenges are increasingly on the minds of many investors, who take the view that the world’s energy systems are only going one way – towards cleaner and more sustainable models. “Everyone is now on notice,” says Geoff Eisenberg, Partner, Ecosystem Integrity Fund. “We have to change course and that impacts every sector from energy, transport and agriculture through to industrials and chemicals. The economics have also flipped. Going green is now the more profitable direction.”
Indeed, those burned by past experience of investing in renewables and clean technology may start to revisit the space in a way they may not have considered just a few years ago. “Cleantech 1.0 was all about big, science-heavy projects as people sought to come up with ways to disrupt commodities,” says an energy transformation investment specialist at an asset manager. “Some did well, but many didn’t because they were trying to compete with commodities when their only value proposition was that they were green. Today, the technology has improved so much that the climate-friendly solutions are better than the incumbents they are replacing.”
Further, the energy transition space recently received a major boost in the US with Joe Biden’s Inflation Reduction Act (IRA). While it encompasses a range of measures to reduce deficits and improve access to healthcare, a significant element of the law is aimed at boosting renewable energy and cleaner power sources, including over US$1 trillion targeted at energy investments. “This is great for the industry,” says the energy transformation specialist. “The government plays a key role in funding projects that purely commercial investors can’t to get them to the point where commercial capital can come in.”
Cynthia Jaggi, Partner, Climate Adaptive Infrastructure, agrees. “The IRA is an acceleration of all the megatrends in responding to the climate crisis,” she says. “Now, there is a more focused and meaningful set of commercial incentives on the table.”
One example of this is in the development of green hydrogen. “We have a ten-year plan now,” says Eisenberg. “That’s a business cycle. The fact that there will be a US$3 per kilogram hydrogen subsidy is a game-changer. We looked at hydrogen previously and it was on the margin of whether it was viable, but the subsidy means that it’s in the money now.”
The direction of travel, combined with government action is clearly creating more incentives for LPs to up their exposures to energy transition-related opportunities. However, this shift can present LPs with some portfolio construction conundrums. “The definition and profile of energy assets have changed,” says Levine. “Fifteen to 20 years ago, it was about oil & gas and what was investable in that space. It often sat in natural resources exposure. Today, there are so many avenues through the value chain, including infrastructure and midstream services and through different forms of energy, encompassing renewables and battery technology. Some LPs are struggling with where to put energy transition investments because they are more like growth equity. Should they, for example, be in private equity or in venture capital?”
The answer will likely vary according to LP and will also change over time as many of the opportunities reach maturity – something that could happen relatively quickly.
We have to change course and that impacts every sector from energy, transport and agriculture through to industrials and chemicals. The economics have also flipped. Going green is now the more profitable direction.
The disruption in both the short and long term, however, means that there will be big opportunities across the energy spectrum for LPs. “We are in probably the most exciting times for energy as a whole,” says Agarwal. “The broadening scope of assets means investors have flexibility to change their view as they continue to observe market movements and see what peers are doing, including shifting some strategies for short-term gain. Ultimately, however, there does need to be a focus on the long term to address the question of: where will we be in 10 years’ time? We won’t turn green overnight, but we can no longer swallow a 30-year business plan as we transition away from fossil fuels.”
Conventional energy is now much more about cash flow generation and returning cash to equity holders
