Michael Morosi, fund manager at MAPFRE AM
It has been three weeks since the most important, slowest moving evolution in the global economy culminated in a historic implosion. No, I am not referring to the approval ratings of elected officials across the globe as they attempt, at times futilely, to create a policy response to the pandemic. Rather, I am alluding to the fateful Monday in April that the price of West Texas Intermediate crude oil closed the trading day below -$35 per barrel.
While the crash is as attributable to ill-conceived financial products as market fundamentals, three weeks later the price of oil continues to plumb lows last seen nearly twenty years ago. With full oil tankers idling outside of ports worldwide, the global energy industry has reached its capacity to store excess crude oil inventory.
The oil market finds itself in this most unusual new normal not because of the unexpected decision by Russia in March to disregard calls for further reductions in output by its OPEC+ peers, nor is it because of the unprecedented demand destruction brought about by the global COVID-19 pandemic. Surely, these factors have been integral catalysts, but the reality is that a more fundamental — even elemental — force is at play.
The simple fact is that the electron has displaced the carbon atom as the essential source of global energy.
Specifically, predictably cheap electricity from renewable sources is replacing dirty, volatile, and largely uneconomic crude oil, and this will have a profound impact on global economies and the investment landscape for decades to come.
The old most important relationship in the energy world
Until 2008, the price of oil and natural gas moved in lockstep, reflecting the difference in the energy content of the materials plus the transportation costs of bringing the less-dense natural gas to end consumers via pipelines. This resulted in an oil-to-gas price ratio in a relatively tight range of 6:1 to 10:1. For example, before the Global Financial Crisis, if the price of oil were $40 per barrel, we would expect the price of natural gas to be approximately $5 MMBTU.
We can see how this relationship held remarkably steady until suddenly it did not.
What happened? In short, it was the shale revolution. Energy producers across the world developed a new way to access vast reserves of natural gas and oil that trapped in tight rock formations using horizontal drilling techniques known as fracking.
Regions with shale gas formations and where the controversial horizontal drilling techniques were permitted found themselves awash in natural gas, as the new wells produced at ten times the rate of conventionally drilled wells.
Considering its lower density, it is expensive to transport natural gas and convert it into compressed or liquid forms to use as a transportation fuel. While cheap natural gas replaced coal in electricity generation, the lack of substitutability as a transportation fuel led to the price of oil and gas decoupling from its historic relationship.
Crude oil production has also ballooned because of fracking. Oil production in the United States bottomed at five million barrels per day in July 2008 and by February 2020 increased over 150% to thirteen million barrels per day.
The United States is now the global leader in oil production, producing roughly 20% more barrels of oil per day than Saudi Arabia.
The new (old) most important relationship in energy
While the shale revolution garnered most of the headlines in the first five years of the recovery following the Global Financial Crisis, an equally momentous shift in the energy market was brewing.
The cost of producing wind and solar power were rapidly falling. Adjusted for capacity improvements, the price of wind turbines declined 45% since 2008, while the price of solar panels declined 90%. Coupled with construction efficiencies and standardized financing, this has reduced the unsubsidized levelized cost of energy for renewable electricity below the cost of conventional fossil fuel for the first time in history.
Over the past five years, renewable energy has accounted for roughly 75% of new energy capacity. Renewable energy accounted for 35% of total electricity generation in Europe during the fourth quarter of 2019, and it represents a growing percentage in other major markets like China (27%), India (21%), and the United States (18%).
So the world is awash in cheap energy, primarily in the form of renewable electricity, just like during the shale gas revolution. Will a similar lack of substitutability of the products cause oil to remain relatively expensive as electricity prices plummet?
In short, we argue that it’s different this time. We estimate that global battery production will increase ten-fold over the next five years. This will enable electric vehicles to increase from roughly 3% of new vehicle sales to as much as 1/3 of the global passenger vehicle market.
Because of this seismic shift in EV market share, the electron will replace the carbon atom as the most important incremental source of transportation fuel. With wind and solar energy accounting for the largest share of new electrons, inexpensive renewable energy is quickly becoming the marginal price setter for the global energy market.
And just how much cheaper is “filling up your tank” with clean energy than a gallon of gasoline? Our estimate is that EVs cost anywhere from 33% to 55% less to fuel than an equivalent gasoline-powered car. For example, a Tesla Model S with a 75kWh battery and a range of 250 miles costs around $10 to fill up, or roughly 4 cents per mile. A similar gasoline-powered vehicle that can travel 30 miles per gallon costs 6 cents per mile in the United States or 9 cents per mile in Spain.
The bottom line is that batteries are breaking down the issue of substitutability in transportation fuels. It follows that we are likely to return to a world in which the price of oil relative to natural gas recouples with its former energy content equivalence of 6:1 to 10:1. With natural gas prices hovering around $2 MMBTU, we could be looking at a long-term oil price in the range of $12 to $20 per barrel.
What does all of this mean for the global economy and markets
Simply put, the most fundamental driver of inflation in an economy is the price of energy. There are few instances in history of generalized inflation absent a spike in the cost of energy.
For example, the catalyst for the last global recession was not the imprudent lending practices of mortgage brokers leading to a housing crash, rather it was the inability of global central bankers to respond with adequate monetary policy as the price of a barrel of oil rocketed to historic highs of $155 in July of 2008. It wasn’t until the economy began to slow materially during the third quarter of 2008, causing oil prices to plummet more than 75%, that central bankers were able to take the drastic measures required to boost liquidity that ultimately stemmed the tides of the crisis.
A prolonged period of low commodity inflation brought on by the widespread adoption of renewable energy and EVs has profound implications for the global economy. For example, low energy inflation gives central bankers additional freedom to execute “whatever it takes” mandates and pursue increasingly aggressive monetary interventions.
As it relates to the equity markets, low long-term interest rates and unconventional monetary policy like quantitative easing primarily benefit the valuations of companies with long-term earnings growth visibility, like the technology, utility, healthcare, and consumer sectors. On the other hand, this backdrop is clearly problematic for the vast majority of companies in the oil and gas sector.
The MAPFRE AM Good Governance Fund exited its remaining oil and gas positions entering 2020. In its place, leading global renewable energy developer EDP Renewables has been a top-five holding, and the fund has maintained a consistent overweight in the technology sector, including companies like Amazon.com, ASML, Salesforce.com, and PayPal Holdings, along with long-term growth stories like Starbucks and Medtronic.
Further, we are actively looking to initiate new investments in companies benefitting from the ongoing energy transition, including companies operating in the supply chain of “bridge fuels” like liquefied natural gas (LNG), renewable energy developers, and companies that supply renewable energy equipment and services.
The energy transition has far-reaching effects on the global economy that go well beyond the headline oil price. The MAPFRE AM Good Governance Fund takes a holistic perspective of these changes and invests in management teams who are allocating capital responsibly and building resilient, future-proof corporate cultures.
This focus on Governance (“G”) has allowed us to manage the portfolio’s Environmental (“E”) risk and avoid exposure to the oil market crash, instead focusing on compelling long-term beneficiaries of the energy transition, including those from seemingly unrelated industries.