Key Questions: What Is the Investment Case for Traditional Energy?

In an investment world dominated by headlines regarding artificial intelligence, investors have understandably bid up technology stocks. As investors often do, it’s tempting to get caught up in the next big thing. And for those who were early, it’s been lucrative. Despite the excitement in new technology, we believe an opportunity has emerged in an old industry: energy.

When investors think of energy, they likely imagine dirty oil wells or filling their car with gasoline. Regardless of what is pictured, rarely is energy associated with an exciting investment opportunity. While we disagree, it’s hard to blame that thinking. In their 2023 global outlook, the International Energy Agency (IEA) outlined a gloomy outlook for the traditional energy industry comprised of pessimistic demand forecasts for oil and natural gas and a pronouncement that renewable energy would be crowned the winner in the energy transition before the end of this decade.

Beyond the seemingly uninspiring fundamentals, investors have been burned on Energy before (pun intended). A hydrofracking revolution in the mid-2010s led to a flood of crude oil supply, which was great for consumers via lower gasoline prices, but horrible for oil producers. Then, as the companies began to generate positive returns, the global pandemic caused demand for energy to plummet, decimating oil prices and, consequently, energy stocks. In fact, over the past 10 years, the energy sector has been the worst performing sector on a total return basis. 

In our view, however, it would be wise to invoke a well-known sports metaphor: skate where the puck is going, not where it has been. We believe the proverbial puck points in the direction of the energy sector with a fundamental backdrop that is the strongest in decades.

Our call is simple: the world needs oil and gas, and it will need these fuels at a quantity far greater than consensus demand estimates suggest. While the IEA and other economists estimate that energy demand will fall over the coming years, we can’t fathom such a position in the near term, let alone the next few decades. Our conviction is inspired by the readings of an English economist born in 1835 named William Stanley Jevons. Jevons, while studying coal consumption in Victorian England, concluded that improved efficiency increases consumption. We believe that as was shown with coal consumption in Victorian England, so too will Jevons Paradox be proven true with oil and gas in the 21st century.

But wait, isn’t increased efficiency supposed to reduce demand? Isn’t that the point of the EnergyStar sticker on my washer and dryer advertising lower power bills and less energy consumption? For an individual, yes. But in the aggregate, not at all. Jevons Paradox works in two ways. First, better efficiency results in increased consumption via increased adoption of the technology. Secondly, better efficiency concurrently results in increased economic growth.¹ Several examples of this economic theory exist today. The average automobile continues to be more fuel efficient, yet gasoline demand hasn’t faltered. Home heating and cooling systems are vastly more efficient, yet Americans have nearly doubled the size of the average home (offsetting the decrease in energy consumption).

When energy demand models are framed with the correct (albeit paradoxical) view that increased efficiency results in increased demand via increased adoption, we conclude that global energy demand will be more robust than ever. We believe that emerging markets will continue to drive energy demand growth as they catch up to the more efficient technologies of more developed nations. China, as an example, has not reached peak power demand from coal yet. As their economy grows and they continue to adopt more efficient energy technology, their energy demand will also grow.

Hopefully, we have demonstrated some contemporary examples of why we believe that energy demand will continue to increase compared to some less optimistic views. But why do we believe that this energy growth will come from traditional energy sources versus renewable energy sources? For this answer, we turn to physics, grid reliability, and consumer preference.

Renewable energy is less reliable than an oil- or natural gas-burning power plant. An oil- or gas-burning power plant can produce electricity day or night, rain or shine. A solar panel can only produce electricity when there is sufficient sunlight, and a wind farm can only generate power when the wind is blowing. As artificial intelligence fuels demand for data centers, demand for traditional fuel sources will increase to keep these data centers powered around the clock. 

Outside of the AI theme, consumers simply prefer traditional fuel sources. For example, Americans have broadly shunned electric vehicles (EVs) in favor of gasoline-powered internal combustion engines (ICE). A recent AP poll found that nearly 50% of Americans are hesitant to buy EVs, citing range anxiety and higher costs than ICE vehicles². Consequently, reliability issues and insufficient charging infrastructure have led to most of the automakers revising their demand estimates lower.

In fact, a recent study shows that nearly 50% of EV owners plan to buy an ICE vehicle as their next auto purchase. EV re-adoption is approximately a coin-flip, and this low level of re-purchasing illustrates that consumers aren’t yet sold on the technology. Such a phenomenon is also not uniquely American. In Norway, a country touted as an early adopter of the EV movement, drivers continue to show a preference for ICE vehicles. EVs have long been heavily subsidized in the Scandinavian nation, but in 2022, Norway dropped several subsidies and EV sales almost immediately fell 20%. Despite years of subsidies and public policy pushes to adopt EVs, approximately two-thirds of Norway’s EV households own at least one ICE vehicle. When consumer choice exists, consumers broadly choose ICE vehicles over EVs, further supporting our case that traditional fuels will continue to be demanded at robust levels³.

Beyond the demand side of the fuel equation, energy companies (particularly oil and gas companies) have shifted their priorities by becoming more shareholder aware in the process. Before the mid-2010s, there was a notion of deploying considerable capital to drill more wells and produce more oil or gas than competitors. This idea, combined with the wave of supply from the American shale oil revolution, flooded the market with cheap oil and bankrupted scores of producers. Oil companies muddled along in a cheap oil environment from late 2014 to 2020, until the global pandemic delivered the final blow for even more of these companies. After eviscerating shareholder value, oil executives had a reckoning, slashing CAPEX (capital expenditure for investment in the business), moderating production, and returning cash to shareholders in the form of dividends or stock buybacks. At this time, there was a view that oil demand would be reduced in the coming years in favor of subsidized renewable energy. The idea for a number of these companies was that they would quietly wind down over time and essentially buy back the company or pay out most of the value to shareholders in dividends.

But as we are seeing today, the future demand picture looks increasingly robust. Oil companies are split between maintaining the strategy of continuing share buybacks or ramping production higher in anticipation of future demand. Those companies that want to restart production will be faced with many months to years of searching for sufficient oil reserves, drilling oil wells, and building the infrastructure to bring these fuels to market. While supply can take years to come online, demand takes considerably less time to materialize. Years of chronic underinvestment in the energy complex has led to a fuel market that is structurally undersupplied. In one view, the world will be undersupplied by a whopping 20 million barrels of oil per day by the end of the decade.

With the S&P 500 energy sector trading at the lowest price/earnings multiple and second highest FCF yield (versus other sectors), valuations are compelling. Combine compelling valuations with a structurally undersupplied energy market in the face of increasing power demand, and we are led to believe that investors have unfairly discounted the sector. As such, we believe that the energy sector can be a powerful, unexpected source of performance going forward.