ESG is an acronym for “Environmental”, “social” and “corporate governance”, the three central factors in measuring the sustainability and ethical impact of an investment in a company or business. It basically means, invest in things that make the world a better place, or putting overall value creation above short term profit.
With the environmental challenges we face, socially responsible investing has certainly come to the forefront of investor mindsets. With the number of actively managed investments (selective valuation and selection of companies versus passive funds that buy and sell indiscriminately) continuing to decline, “Divest Harvard” continuing to demand the endowment divest completely from fossil fuels, and figures such as Greta Thunberg becoming pop culture icons, it seems as if much of what little active investment is now occurring might just be ESG related.
If you do a quick Google Trends search, you can see that ESG has been growing in interest over the past few years. For comparison, I’ve selected “IMO 2020”, which is the fuel change in the maritime industry which will go into effect at the end of this year. IMO 2020 is perhaps the most important piece of environmental legislation *ever* passed, and it will have a massive impact on global sulphur emissions.
Sulphur oxides (SOx) are known to be harmful to human health, causing respiratory symptoms and lung disease. In the atmosphere, SOx can lead to acid rain, which can harm crops, forests and aquatic species, and contributes to the acidification of the oceans. — IMO
It’s a good thing, and according to some economists and consulting groups, it’s the biggest change *ever* to the energy markets.
“It is the biggest change in oil market history,” — Steve Sawyer, senior analyst at energy consultant Facts Global Energy
As you can see, IMO 2020 is just a blip on the radar screen, while ESG volumes are massive and trending up. As the top economist at PwC recently said in an interview with CNBC Africa, “It’s just 5 weeks away and we only just came out with our report.”
I don’t think I need to expound on the case for why IMO 2020 regulations are a good thing from an ESG perspective. The big question is, why isn’t this event on more radar screens?
Oil Companies Have a Bad Rap
Oil and coal companies are directly responsible for pushing more bad stuff into the atmosphere than anyone else, it’s true.
What’s also true is that our existing global energy infrastructure is completely reliant on oil companies. Without oil, our civilization stops. Period. We’re back to horse and buggy. You may say, “sure, I could deal with that.” But could you? Global supply chains are now inextricably interwoven. The reality is that most places on the planet, and especially cities, are now unable to produce the things they need for basic survival. We’ve built a global system, and now we need a global system to survive.
The truth is, oil companies aren’t solely to blame for our current massive carbon footprint. We’re all to blame. Unless you’re tilling fields and churning butter by hand, making your home from local timber (i.e. living amish), the carbon footprint of oil companies is your fault. You wanted cheap clothes from China and electronics from Taiwan.
Anyway, oil companies just provide the fuel. We burn it to get what we want and need.
A Brief History Lesson
Ever heard of a catalytic converter? It’s the thing in a muffler of a car that removes carbon monoxide, nitrogen oxides, and hydrocarbons. It’s what makes it bearable to be in cities with a lot of traffic. Widespread use began in 1975 when environmental regulations mandated their use in the United States, and also required that tetraethyl lead be removed from fuels. Between 1973 and 1975, pollutants from vehicles with catalytic converters installed dropped by over 90%. The results? Well, for one, a lot more demand for platinum and palladium (also note the big spikes in the charts below when automakers switched metals)…
IMO2020 is a similarly ambitious regulation, and like catalytic converters in the 1970s, it’s going to cause massive disruptions in multiple areas.
If you invested in an automaker in 1973, you would have helped them finance the transition to much lower net emissions. Similarly today, by investing in the IMO 2020 value chain, you are helping them fund this round of environmental changes. In 2030, we have yet another round of changes, which focus on carbon emissions vs sulphur emissions (and promise to completely upend the dynamic of international trade and finance yet again).
Because of a wrong-headed approach to ESG investing, which penalizes fundamental parts of the value chain while rewarding downstream consumers, (i.e. rewards Tesla while disregarding the energy expenditure and environmental impacts of producing lithium batteries), companies in the oil value chain have been starved of capital. As a result, many of them have become extremely efficient and currently offer incredibly attractive long term investment prospects.
The Value Chain
Oil gets pulled out of the ground somewhere. Maybe Saudi Arabia. Maybe Texas. Maybe Nigeria. Maybe the North Sea. In an IMO 2020 world, the most desirable oils (those with the lowest sulphur content) come from places like Nigeria, West Texas, and the North Sea. Just think, by investing in a Nigerian oil company, you could be helping them get the capital they need to build new infrastructure (mainly refining, transmission, and storage), and pull their people out of poverty. In fact, Africa imports much of its refined fuels (surely you’ve heard of gasoline shortages in Nigeria), resulting in a greater overall environmental footprint than if they produced and consumed fuels locally. My bet: your money will have a more positive impact on the lives of Africans if invested with an African energy company than if given to an NGO operating in Africa.
Oil then needs to be refined into something useful. For that, we have pipelines and ships. Most oil is delivered by ships. Very, very large ships, the biggest of which are so large that they can’t pass through the Suez or Panama canals. A VLCC — very large crude carrier — is 4 times larger than the largest boat that can pass through the Panama canal.
Oil is delivered to either a trader (who stores it hoping to sell it for more later), or directly to a refinery or a nation state (who may put it in their strategic reserve). Ultimately, the oil ends up in a refinery, where it is processed, stored again, and then shipped to a customer somewhere on a product tanker. It’s then stored until consumed by you, the consumer, for your transportation, logistics, entertainment, or survival needs.
There are only a few thousand vessels transporting crude oil and refined products. These are called “dirty” and “clean” tankers respectively.
Where I’m Invested
The last big energy boom occurred before the last financial crisis, with another decent run in 2015. In recent years, anything involved in energy has been toxic territory, “untouchable” by many investors and funds. Combined with the move to passive and algorithmic investing, and you have a situation where capital appears to be extremely misallocated across the energy sector. Valuations and yields appear wildly attractive.
Personally, I think complex refineries (refineries that can process heavier crudes and waste oils to produce distillates and lower sulphur residuals) and oil tankers — “clean” and “dirty” — present superior investment prospects. This is how I’m currently allocated:
I currently have more than 35% of my net worth allocated to this trade and my goal is to have 80% of my net worth allocated to this trade by the end of the year. This is absolutely insane and any investment advisor will tell you never to do this, but I believe I’m right and I believe concentration leads to serious outperformance.
Refineries are extremely complex and I haven’t delved too deeply into the economics on the refiner side (although I do know that “complex” refineries — i.e. high Nelson Complexity score, should have the best margins) so I only have a little bit of money parked there. The best thing the refineries do is tell me more about what’s going on in the fuel markets, and in demand for tankers. For instance, a lot can be inferred from variations in the stocks of distillates, or from widening crack spreads, or preferences for different crude grades. However, the comparative performance of refineries is frankly harder for me to understand right now, so I’ve focused more on the tanker side, which I find elegantly simple.
Essentially, tankers have a practically fixed operating cost. Beyond that level, it’s pure profit. When the supply/demand dynamics favor the tankers even a little bit, tankers can literally make hundreds of times more than they could even days before. Hence, if you’re talking about a long term cyclical change, you’re talking about some nutty upside in share prices.
The bull thesis for tankers essentially comes down to the following:
- IMO2020 will create an increase in demand for dirty and clean product transportation (and we can see that this is already happening)
- There aren’t many new ships coming on the market (low order books — i.e. lowest since early 2000s)
- Due to uncertainty around the future of combustion engine design (we may not even be burning oil in 2050), ship owners are hesitant to order new boats that may be obsolete when new regulations kick in for 2030
- Sanctions on certain companies due to doing business with Iran / Venezuela (removed another 3–5% of supply)
- Seasonality (this is the time of year they normally run, due to demand for heating oil in the northern hemisphere)
The big question right now is how long the cycle lasts. If it only lasts 2 quarters (Q4 and Q1 2020), many of tanker companies stand to make half or more of their current market cap in free cash flow. When the data comes out, this will show some them trading at a P/E of 2 or less. Many of these companies also have 60–80% dividend policies, which means much of this massive cash flow will be delivered directly back to shareholders. In the last bull market, for instance, in 2004 Frontline ($FRO) basically paid out the stock price it started the year at ($90) in dividends, while also doubling it’s share price. A bull market in shipping can be truly epic.
If the cycle lasts a few years, which some analysts predict, mostly based on the supply picture, we could be at the start of a very significant wealth creation event.
The longer term bull picture could be offset by worldwide economic troubles, but at least for Q4 2019 and Q1 2020, it’s already reality, not speculation, that these companies are going to be making double digit percentages of their current share price in free cash flow every month.
If you are interested in learning more about specific companies, I might suggest a subscription to TradeWinds news or signing up at Cleaves Securities for their free weekly research, in addition to reading the quarterly reports of these companies and watching interviews with their executives.
Remember, Oil is Both Part of the Problem and Part of the Solution to the Problem
Investing in oil does not make you evil. Everything we do has both good and bad impacts, and whether those impacts are good are bad largely sway based on who you ask.
Environmental regulations are needed. Decarbonization is needed. But right now, oil is what we have, and companies in the oil value chain are the best equipped to help us transition to a better energy future.
As always, this post is not investment advice, but rather just my opinion. Do your own research and take your own risks. I’m just a guy talking out loud.