Unusual investment opportunities in an atypical energy cycle

World events and the rise of renewable energy are reshaping the energy landscape. The players leading the charge include major traditional energy companies and energy producing nations that see the green transition as inevitable and profitable. Capital scarcity favors leading firms with strong capital positions.

An unusual energy cycle is upon us. While the global price of oil has fallen 15% since April 12th 2023¹, there is no sign a recession at western energy firms. In the US, crude oil output is moving toward record highs. To help replace Russian gas supplies to Europe, US liquified natural gas (LNG) exports surged 45% above their pre-COVID level (Figure 1). At the same time, OPEC reduced output by about 3% through cuts announced in October 2022 and April 2023.

Under normal circumstances, OPEC cuts production as demand falls (Figure 2). That’s not the case just yet. This time around, OPEC is attempting to maintain higher prices in the face of future demand reduction, maximizing the market price per barrel.

This is not welcome news for those counting on lower energy prices, but it does suggest that energy credit and equity investors can view the sector somewhat differently from the typical boom and bust norms associated with prior economic downturns (Figure 3).

We are not forecasting a “new supercycle” for the oil industry as suggested by other firms. Citi Research’s renowned commodities team has been more cautious than many in assessing risks to commodities prices. Increases to petroleum and gas supplies typically lag behind demand recovery. History shows that higher prices will, over time, cause supplies to increase, forcing a new equilibrium to be established. This time, the new supplies will include even faster adoption of alternative energy sources.

That said, capital inflows to conventional, carbon-based energy have returned. The world still relies on six million barrels per day of Russian crude oil exports, even if many western economies refuse to buy from them. Since the beginning of the war in Ukraine, the amount of oil in the US Strategic Petroleum Reserve has declined 38% from end-2021 levels. The US is also buying oil again to build up the stockpile. This need to hold and maintain energy stockpiles, be it oil and gas or renewables, distinguishes the energy sector from other cyclical industries (Figure 4).

As a generally fungible commodity, crude oil trade has been redirected around the world, but the global oil price would be much higher without Russian crude exports to willing buyers. Geopolitical conflicts have and will continue to cause price spikes. Continued conflict in Ukraine and the need for the US and other countries to rebuild energy stockpiles raises the investment and development prospects for non-OPEC producers like Brazil (Figure 7). It also creates sustained opportunities for the renewable energy sector.

Global energy companies invest in the future

Between geopolitical tensions affecting energy supplies and the rise of renewable energy, the energy industry is going through a sea change. Companies are jockeying to maintain dominance in the shifting landscape. They are also mindful of the need to be capital efficient and invest more prudently.

For the past 20 years, European energy companies have been trading at a discount to their US energy counterparts (Figure 6). After reaching lows in 2021, European energy valuations have rallied a bit but remain at a 40% discount to US energy firms. This valuation difference is unjustified as European and US energy companies are similar in many ways. Part of the valuation discount could be due to general European companies falling out of favor with investors. We see this as an arbitrage opportunity favoring investment in non-US firms, a strategy that is consistent with our view that the US dollar has peaked.

Green is the new brown

The European energy companies have been leaders in making structural changes to strengthen balance sheets to deploy capital on long-term projects, including a focus on a green energy transition. We believe these changes will make EU energy companies more valuable, boosting earnings and share prices.

The Middle East is leaning green, too

Meanwhile, growing geopolitical tensions and changing market dynamics have prompted some Middle Eastern countries, particularly Saudi Arabia and the United Arab Emirates (UAE), to invest heavily in renewable energy sources to prepare for an eventual shift in the global energy landscape (See Middle East Strategy). These investments have taken various forms, including the development of large-scale solar and green hydrogen projects and the construction of refineries focused on producing petrochemicals instead of traditional transportation fuels.

The shift by Middle Eastern countries toward renewable energy sources has been driven by concerns over stranded assets and the growing global focus on energy transition, as well as the favorable economics of solar power in the sun-drenched region.

At the same time, Saudi Arabia and the UAE continue to expand their oil production capacity, reflecting their belief that oil demand will not decline as quickly as some expect. This has led to a delicate balancing act, as these countries seek to capitalize on their vast, low-cost oil reserves while also preparing for a future in which fossil fuels play a diminishing role in the global energy mix.

Competition between renewables and carbon energy is intensifying

The global transition to greener energy sources presents a significant challenge for Middle Eastern hydrocarbon exporters, which are heavily dependent on revenues from fossil fuel extraction. The need for large-scale investment in renewable energy infrastructure, coupled with the growing vulnerability of their existing business models, has led some observers to question whether the energy transition could provide the impetus for improved trade and reform within the region.

The United Arab Emirates and Saudi Arabia’s ambitious renewable energy targets, such as the former’s aim to achieve 30% renewable energy by 2030 and the latter’s goal of 50% by the same year, signal a growing awareness of the need for change. By investing in renewable energy projects and infrastructure, these countries are securing their own energy futures and contributing to the global push toward a cleaner, more sustainable energy mix.

As the world continues to grapple with the challenges posed by climate change and the need for a more sustainable energy future, the actions of OPEC+ and major oil-producing nations will play a crucial role in shaping the trajectory of the global energy market.

Consolidation will accelerate the adoption of renewables

Renewable energy is becoming more economically attractive as the price continues to decline and demand increases. Even in the relatively energy-rich US, electric heat pump installations are growing rapidly, and electric passenger vehicle sales grew by 65%, compared with a 14% decline for those with internal combustion engines. OPEC’s production cut means that energy prices will likely remain higher than in previous downturns.

Relatively high oil prices will impact the renewable energy sector unevenly. Established energy firms that already have substantial revenue will have the opportunity to gain market share and acquire valuable human and patent resources from firms less well-positioned to weather the coming downturn.

We see conditions for a round of consolidation in the renewable energy sector, much like we’ve seen with railroads and oil at the beginning of the 20th century and again in the tech sector at the beginning of the 2000s. We view this sort of creative destruction as a feature, not a negative, that is likely to help accelerate the green energy transition.

For investors, selectivity will be key. Businesses with a valuable product or intellectual property asset but no good way of executing on it may be absorbed by entities with access to capital and strong execution capabilities. It’s likely the clean technology (cleantech) sector will end up bigger, though with fewer firms.

What should investors do now?

Investors should consider investing in firms that are cash flow positive and well financed. As access to capital is currently constrained, companies with capital can more rapidly develop and dominate their respective markets.

Battery, metals, and oil & gas companies that are slowly evolving their business models in a diversified manner may be safer than startups at this stage in the economic cycle. Startups are typically more reliant on government policies that focus on grants instead of consumption stimulus. But as the green energy industry matures, government funds are shifting from research to consumption stimulus. Larger electric vehicle companies are focusing on vertical integration, which could lead to some consolidation. As battery companies try to secure mineral supply, some startups may fail, and their assets will get sold off. For better or worse, in this cycle the winners will be able to compound their returns.

Large companies are facing meaningful challenges, such as carbon taxes. Firms that can either generate offsets or reduce carbon emissions create more value. For example, a tax refund on an electric vehicle will benefit larger companies selling more vehicles, while smaller companies will be less able to capture as large a share of government spending.

Like 1998, this is a moment of consolidation and strategic decision making that will decide winners and losers over the coming decade and beyond. Ultimately, we see a stronger, growing, and developing energy industry, one where old and new energy will evolve toward a different mix that will ultimately benefit society. We believe this is a historically important moment for cleantech — many of the winners of the next few decades will be decided. Therefore, it is particularly important for investors to focus on cleantech companies that are consolidating and gathering strength. Investors can also add to leading energy firms whose cash flow, efficiency and focused strategic execution will allow them to seek distressed opportunities and attract more capital for sustained growth.