ESG 2.0: Substance, virtue signaling, profitability

Substantive ESG is needed, virtue signaling contributes to energy crisis conditions, both improve oil industry profitability

Earlier this week I participated on a panel at the Goldman Sachs Global Energy and Clean Technology Conference that discussed the role of ESG and energy transition within the traditional oil & gas sector. ESG is one of those topics that I think has gone somewhat off the rails especially as it relates to the traditional oil & gas industry. The virtue signaling aspect of ESG and energy transition should be a turn off to everyone, and, I believe, runs the risk of doing meaningful harm to the least affluent among us, as we can see in Europe’s energy crisis environment. However, what I might call substantive ESG is indeed needed in the traditional oil & gas space. Counter to what I suspect some (many?) believe, I see substantive ESG as being a driver of improved levels of through cycle profitability, cash returned to shareholders, and resiliency to both normal oil & gas cycles and a long-term energy transition.

In my view,

• ESG is not an asset class, it is a philosophy on how to run a company. It’s not about glossy brochures; it is about being a sustainably profitable company over the long run. A simple example is the failure of the well IRR model that didn’t sufficiently consider infrastructure and other costs needed to properly develop a shale oil field (which I wrote about here). We ended up with a worst of all worlds outcome: over drilling, poor returns on capital, and excessive methane flaring/venting. Profits and the environment both lost.

• The fact that some are using ESG as a backdoor path to purse public policy initiatives that governments themselves are not able to enact or pursue is unfortunate. In a nutshell, I see these efforts as contributing to current/future energy crisis conditions. Such a path is undoubtedly bad for the world’s non-affluent, but is likely to lead to improved profitability for energy suppliers. We might call this the societally unfortunate path to improved returns on capital.

• So for those of you that are especially skeptical of the ESG movement, what is it about ESG that is so upsetting? You either have a better run company or energy crisis conditions or, perhaps most likely, both.

• For those in the “oil is evil” bucket, I’ll say this: we will never solve climate change without first, or simultaneously, ending energy poverty. There is precisely a zero percent chance we will address the energy needs of 7-9 billion people on Earth with only renewables and “electrify everything” by 2050. This is not about what we want or wish could happen; it’s about the physical realities of providing massive amounts of available, affordable, secure energy to meet the world’s growing energy needs.

Examples of where substantive ESG is needed and will be good for profitability

I will use the shale E&P experience of 2010-2019 to illustrate the shortfalls of not being a sustainable company and how it hurt profitability. I am not trying to (further) pick on the shale industry; rather, I will guess most readers have a familiarity with it that makes it the right choice to write about in this ESG 2.0 post.

E - Methane

Addressing methane is the area where the goals of climate change mitigation and improving industry profitability I believe most closely align. To simplify a complex issue, if an E&P is forced to consider infrastructure and life-cycle costs, including methane containment (i.e., an ambition of zero methane flaring/venting/leaks), the temptation to over drill due to mis-leading well IRR economics is significantly reduced. By definition, a sustainable company is thinking about life-cycle costs, infrastructure, equipment, health, safety, and the environment. Drilling programs will only be pursued when the commensurate infrastructure is in place and accounted for, both physically and in economic terms. In my view, you will end up with both slower supply growth (a good thing) and a properly-paced drilling program that definitionally incorporates all costs, not just the well drilling expense.

The fact that sustainable development was not pursued by much of the shale E&P industry during the 2010-2019 boom years is revealed in the very poor profitability the industry demonstrated. This is meant as just one example where ESG and profits are positively correlated.

Shale E&Ps were “not for profit” over 2015-2020

In my view the benefits of methane containment extend beyond simply a more thoughtful resource development program. The fact that there is any question that natural gas is an excellent coal-replacement fuel that can generate non-intermittent, base-load power is a black-eye for the oil & gas industry. That is especially true today when a combination of technology and cost understanding has made the issue of substantially addressing methane flaring/venting/leaking a solvable issue. An industry solution is needed; well-intentioned company-specific promises I don’t think will get the job done.

S & G - Perspectives, pushback, and oversight

If you attended any US energy sector investor conference during the 2010s, you would be struck by how similar the plans and strategies were for most E&P companies (and I am well aware that not much has changed if you have attended recent industry conferences...only the messaging sounds better). The basic shale pitch was as follows: (1) we have amassed a meaningful position in the next great shale basin; (2) we have X number of locations over our Y-sized acreage position that provides a Z year inventory of drilling locations; (3) our half-cycle economics break-even at some low oil price; (4) at consensus oil prices, the drilling program generates exceptionally high rates of return; and (5) we trade at a sharp discount to the net present value of this acreage position.

I have already addressed the failure of the drill-baby-drill well IRR model that characterized Shale 1.0 (here). The issue today is why did so many companies pursue such similar strategies with near identical messaging that ultimately yielded such poor financial performance for most? Was there any debate within a company’s management or employee base as to whether the well IRR model was working as advertised? Where was the pushback from Board members when companies were clearly not achieving commensurate corporate-level returns that would go with the supposedly highly profitabile drilling programs? And to be clear, this is not about being perfect; when you take a risk, mistakes can be made. My focus is more about the group-think and uniformity of the approach to Shale 1.0.

If you can do the hard part of ultimately producing oil and gas, why the group think on strategy and capital allocation? It doesn’t make sense. My suspicion is a lack of substantive diversity within managements and Boards was the problem. Are there people from different backgrounds, regions of the USA, or from around the world that bring unique perspectives to strategy and capital allocation? I do think it is probably harder for investors to discern between check-the-box diversity or whether real discussion/debate occurs; I don’t have a good solution on how to fix that.

Will diversity on its own improve profitability? How could it hurt to try? The industry was not-for-profit from 2015-2020 and barely cost of capital over the previous five years. It would be really difficult for me to think how the industry wouldn’t benefit from an infusion of fresh perspectives, especially here at the start of a multi-decade energy transition era.

Energy transition resilience

The notion that companies should be resilient to the ongoing energy transition I think is going to prove to be one of the best parts of the ESG movement. What does resilience mean? Here’s my list, which I will elaborate on in a future post:

1. Double-digit full cycle returns on capital (best-in-class is 15%-20%+) and at least break-even at trough of cycle (best-in-class is 8% at the trough).

2. Fortress balance sheet.

3. HSE (traditional health, safety, environment) leadership plus net zero Scope 1 and 2 emissions by 2050 and verifiable short- and intermediate-term goals.

4. Technology leader, including for finding and developing oil & gas and in regards to emissions reduction technologies.

5. Attract, develop, and retain a globally diverse talent pool (employees, management, board).

I don’t personally list “ESG” as a specific goal. It’s implicitly if not explicitly incorporated in all of the items above.

What is NOT included in my transition list

• Divestiture from the oil & gas industry. The last thing the world needs is to kill the western oil industry and leave everything in the hands of non-US/Canadian/European state-owned enterprises. It is true that some companies will naturally choose to sell or merge; that is healthy. But asking/requiring/demanding western oil and gas companies to shrink in aggregate I do not believe makes any sense, especially for the non-affluent among us.

• Specific production growth targets. Rather, oil and gas companies should look to meet the energy needs of consumers/businesses, recognizing the band of outcomes is wider going forward than it was historically, in particular for crude oil (global natural gas growth seems more of a certainty; for the record I believe oil demand will grow at least through 2030).

• Specific “new energies” CAPEX or capital employed objectives. This one is the biggest source of ESG mystery to me. Why on Earth does any investor care whether the top seven or eight western oil companies invest in new energy technologies? Maybe some should, but as a requirement for being a good ESG or energy transition steward? Give me a break.

Virtue signaling good for creating an energy crisis, bad for the non-affluent

As climate enthusiasts have infiltrated the investor ESG space, we are seeing a blurring of the lines between traditional government-driven public policy initiatives and what is now being asked of private corporations. This is unhealthy, in my view. Yes, private companies need to be responsive to what consumers, customers, and investors want. But one-sided ideologies that believe addressing climate change takes precedence over ending energy poverty I don’t think will succeed and risk the worst-of-all-worlds (for citizens) outcome of high and volatile energy prices without any real change to the climate trajectory.

A few examples of ill-advised virtue signaling:

Divestment and investment blocking

Growing calls to inhibit the free flow of capital into fossil-fuel energy supply projects—before energy poverty has been eliminated—are misguided at best and downright evil at worst. At a time we have not ended energy poverty and everyone aside from the affluent are dependent on affordable, available, secure energy (even the affluent need the latter two to be true), the notion that a vocal group of rich country investors and climate enthusiasts can dictate what is acceptable and what is not from an energy supply investment standpoint needs to be stopped in its tracks. Push back hard on this if you care even a little bit about those less fortunate than all of you who read this post.

At a minimum, the combination of divestment and “no new capital” is mostly geared at US/Canadian/European companies. Can anyone explain to me how this will help ensure we do not have an energy crisis or that it would somehow lead to CO2 reductions? The most important energy commodities are global in nature with resources present around the world. Ending investment in US/Canadian/European fossil fuel companies/projects will only divert capital to other areas.

Blocking North American pipeline/infrastructure

There is perhaps no action that does more damage to more people around the world with at best zero environmental benefits and potentially a large negative impact than the act of blocking North American oil and gas infrastructure. This is as ill-conceived as it gets when it comes to the climate movement.

If you really feel the need to block oil and gas infrastructure, I would suggest protesting the lifting of sanctions on Iran or the Nordstream 2 gas pipeline from Russia-to-Germany or any number of international projects. To be clear, I am not in favor of this, but if you feel so compelled to hate on the oil & gas industry, at least recognize it is a global business. From my American perspective, everyone on Earth is better off with a healthy and profitable North American and European oil and gas industry. It’s not a close call. Between CAPEX and jobs and inexpensive, available, secure energy supply, cutting off your nose to spite your face makes zero sense.

With that said, a version of the earlier methane critique applies here: it should be a key goal for North American oil and gas producers to ensure they produce “the cleanest barrel or Mcf in the world.” The domestic industry does not yet have that goal; it should.

Check the box diversity

I touched upon this above. The flip side of the need for diversity is the risk we get the “check the box” variety. I am not sure I have any great suggestions for investors on how to evaluate this from the outside. Suggestions on externally identifying the difference between substantive and check-the-box diversity is welcomed.

On a personal note…

In sticking with the ESG theme, I was pleasantly surprised to have had the following sustainability encounter with the friendly cashier at Village Market in Ketchum, Idaho last week.

Me: (Unloading groceries from cart to scanning area)

Cashier: Would you like paper or plastic?

Me: Wow! You are giving me a choice of paper or plastic? Really?

Cashier: (looking at me quizzically I am sure thinking this guy must be drunk.)

Me: I am very excited to have the choice of plastic. They banned plastic bags where I live.

Cashier: They banned plastic bags? Why? Where is the place you come from that banned plastic bags?

Me: New Jersey.

Cashier: New Jersey?!? I can’t imagine such a place.

Me: Actually, I like New Jersey but the coastal elites that run the state have gone a little crazy with some of this virtue signaling stuff around climate. I’ll take plastic!

Cashier: Be careful holding the bags. They are eco-plastic and will break easily. In Peru, we use normal plastic bags.

Me: God Bless Peru.

Disclaimer

I certify that these are my personal, strongly held views at the time of this post. My views are my own and not attributable to any affiliation, past or present. I will observe that it is difficult to write about ESG without coming across as a “moralist” or “preachy”; that is not my intent and I apologize if any part of this comes across that way. The only exception to that point is I do preach the primacy of competitive through-cycle profitability within a pro-capitalism, anti-socialism belief system. This is not an investment newsletter and there is no financial advice explicitly or implicitly provided here. My views can and will change in the future as warranted by updated analyses and developments. Some of my comments are made in jest for entertainment purposes; I sincerely mean no offense to anyone that takes issue.

Regards,

Arjun