Energy and ESG Can Co-Exist

Overall, demand for oil fell about eight million barrels of oil in 2020, much of which was due to lower demand for travel, says Brahm Spilfogel, vice-president at RBC GAM, and co-manager of the fund. A McGill University graduate in 1991, Spilfogel joined RBC GAM in 2000, after working for nine years in trust administration and private investment counselling. “As the market re-bounded in late 2020 and into 2021, things began to open up first in the U.S. But each country will follow. As immunization rates continue to move up, we will probably see a 5-7 million barrels a day demand increase in 2021. In the U.S. we are already at pre-pandemic levels of demand, and in China we’re above pre-pandemic levels. Even India is on the mend. These two events explain the down movement and then the upward move we have seen in the last 14 months.”

Although global economies are not back to where they before the pandemic struck, they are getting close. “We’re back up to 98 million barrels a day,” says Beer. “We expect another 2-3 million barrels of oil demand over the next 6-12 months, largely from international travel. We’ll be back to where we started.”

The yo-yo behavior of oil demand is reflected in the performance of RBC Global Energy F. In 2020, the fund returned -23.2%, while the energy equity category lost 26.9%. Year-to-date (July 5) the fund is up 30.12%, versus the category which is up 34.81%.

Can Energy and ESG Co-Exist?

Meanwhile, in the past year the crude oil price has doubled and gone from US$38 to US$73.70 for West Texas Intermediate (WTI). Yet non-OPEC producers, which account for 65% of the market, have been punished because of concerns about ESG and green-house gas emissions and poor returns on capital.

Indeed, Spilfogel points out that a couple of years ago OPEC complained that marginal producers, such as those on the U.S. shale side of the business, were over-producing and effectively driving prices down. A renewed capital discipline has changed things, he argues. “Whether it was luck or good timing, we’re not sure. But investors and [institutional investment] boards and ESG has driven the rest of the market to behave in a more capital-efficient manner as well,” says Spilfogel, adding that the oil price might fluctuate between US$65 and US$75 a barrel for the next year or so.

Structurally, observes Beer, the most positive development for the oil sector is that capital discipline is now taken much more seriously. “Producers are not getting rewarded for growing production. They are getting rewarded for growing cash flow. These stocks won’t be growth stocks in an up cycle. They will be disciplined cash generators.”

In assembling the portfolio, Beer and Spilfogel examine macro-economic issues such as the transition to non-traditional energy sources and electric vehicles. “People are worried about green-house gas emissions. But they are also worried if they buy an oil company how long will they benefit from its oil production? There is the issue of the oil price, which is a function of demand. We look at that longer-term,” says Beer.

From a geographic perspective, 62% of the portfolio is in the U.S., 15% Europe and 17% Canada. “We are over-weighting the U.S. and Canada at the expense of being underweight European producers,” says Beer, noting that the U.S. benchmark weighting is 55%, Canada 15%, and Europe 25%.

How to Pick an Energy Stock?

In selecting individual stocks, Beer and Spilfogel seek several attributes. “We want to understand the company’s strategy and its culture. Companies with high safety protocols tend to do better over the long run. That’s number one,” says Spilfogel. “Second, we want to find low-cost producers with as long-life reserves as possible. The better your reserves are, the higher the return on invested capital over the long run.”

Third, the team prefers to stay in stable political regimes and avoids unpredictable jurisdictions. “One time is too many, when you wake up and find that you’ve lost the right to a company’s resources,” says Spilfogel, noting, for instance, that the several Latin American countries are deemed unsuitable for investment. “We don’t want to see a company’s assets expropriated.”

Fourth, the team has a uniform approach in engaging company management on ESG principles. “We have a separate questionnaire for the extractive industries, particularly oil and gas producers, with respect to greenhouse gas emissions and water usage” says Beer. “We also look at several third parties to determine the consensus.”

Dividends and Gains in Energy

Running a portfolio of 38 names, the managers cite New York-listed producer Equinor ASA (EQNR), which is 67% controlled by the Norwegian state. The firm produces about two million barrels of oil equivalent (BOE), since it also produces natural gas and the carbon dioxide intensity is 60% lower than the global average. “It might grow by another 100,000 barrels by 2030, when it plans on levelling off oil production, which is offshore and in the North Sea,” says Beer. 

Equinor trades at about three times enterprise value to earnings before interest taxes depreciation and amortization (EBITDA). “Equinor generates a lot of free cash flow, which it is paying out in dividends and some share buybacks. The returns on renewable energy look lower, but over the longer term, and with lower greenhouse emissions, it will be valued higher by investors,” says Beer, adding that the stock has a 3% dividend yield.

Another favorite is U.S.-based ConocoPhillips (COP), the world’s largest independent exploration and production oil and gas firm. “We like the management and the culture,” says Spilfogel. “It plans to buy back 50% of their stock over 10 years, which is worth in total about US$42 billion. It has a pretty good return on invested capital of over 10%.”

On the ESG side, the company has committed to reducing its greenhouse gas emission intensity by 25-30%. “It produces about 1.6 million barrels a day, but a lot of that is natural gas,” says Spilfogel. “In a flat-growth world, where it can grow 3% per annum and have a 2.8% dividend and is buying back 5% of its stock every year, then you as an investor have a good shot at making somewhere between seven and 10% a year in the long run.”