Many investors are inclined to exclude fossil fuel companies from their portfolios on the grounds that they are major contributors to climate change, environmental damage, and health risks.  They might instead choose to invest in renewable energy businesses, hopefully because they have done some fundamental analysis that supports a favorable long-term outlook, not just due to concern for the environment.  With the advent of the ESG investing movement, numerous services have begun assigning ratings to public companies that reflect their exposures to, and management of, environmental, social, and governance (ESG) risks and their associated costs.  Companies that manage and mitigate these risks better are expected to prosper and outperform in the long run.  ESG scoring algorithms vary from one service to the next, but at least some of them, not surprisingly, award “high risk” marks to most of the oil & gas sector, due in large part to the environmental component.  Thus, the ESG movement, which has become more influential in the asset management industry over the last decade, is no doubt responsible as well for many investors choosing to dismiss oil & gas.  This is what we at RCA would call “first-level thinking” that ignores certain realities and, consequently, unduly limits one’s investment choices.   Four such realities are worth a brief discussion.

• Oil & Gas will be part of our energy mix for decades, like it or not.  In its roadmap for achieving net zero emissions by 2050, or NZE, the International Energy Agency (IEA) estimates that fossil fuels will have to decrease to about 20% of energy inputs from approximately 80% today to help the world limit global warming to 1.5°C.  The scenario also envisions an 8% overall decrease in energy demand, despite a global economy more than double today’s and 2 million more people.  This still represents a large absolute volume of oil & gas.  (For comparison, the U.S. Energy Information Administration projects a 50% increase in world energy consumption between 2019 and 2050, with oil & gas only falling to 49% of consumption from 54%.)  Unfortunately, the NZE pathway is far from likely, given that it requires drastic coordinated changes to global government policies and $trillions of capital commitments every year until then.  More likely is the trajectory implied by current government policies regarding clean energy as outlined in the Stated (Energy) Policies Scenario (STEPS), wherein oil & gas still account for 60% of energy in 2050.  Most importantly, the goals for a renewable energy transition overlook “the realities of the physics, engineering, and economics of energy systems” required to achieve it.  Given the more likely scenario, the best oil & gas operators would be expected to prosper for decades to come.
• Oil & Gas is no longer just about climate change; it is now also a matter of national security.  Russia’s invasion of Ukraine has changed the narrative on fossil fuels.  Until renewables can reliably supplant the free world’s dependence on oil & gas, it is now an indisputable matter of national security that a reliable supply of these fuels be ensured.  While the invasion has accelerated commitments to renewables development, especially in the EU, it has also bolstered the argument for increasing oil & gas exploration & production.  Therefore, choosing whether to invest in fossil fuels can no longer be seen as a binary choice between protecting the environment (good) and contributing to climate change (bad); oil & gas production means national security for now, and national security is the greatest social impact.
• Renewable Energy is not clean, and its environmental footprint will grow substantially.  Renewable energy must and will become an ever-larger piece of the energy mix if we hope to slow or stall climate change to avoid catastrophic scenarios.  However, the major technologies – solar and wind – are dependent on the energy-intensive mining of a number of critical minerals, massive amounts of concrete production, the use of toxic chemicals, substantial amounts of cleared land, and other environmentally harmful activities. Wind towers are harmful to birds and bats while solar arrays add to habitat loss.  There will need to be exponential increases in the mining of minerals, the energy used for the mining, waste products, etc., to achieve a carbon-emissions-free economy and as pointed out above, that scenario is not even grounded in engineering and economic reality.  None of this also accounts for the disposal of hazardous materials at the end of the useful lives of the equipment.
• Oil & Gas companies will be major developers of clean energy solutions.  The oil & gas industry may, indeed, be critical to the development of clean energy technologies.  The majors have deep experience in mining and in energy technology research, not to mention strong balance sheets to fund the research.  It is also in their interest to help lead the effort, as a hedge against the long-term decline in their traditional business.  Capex spending on clean energy to date has been a small part of industry budgets, at about 5% in 2022, but has been growing at a rate of 12% for several years.

The above reasoning should make clear that choosing one type of energy over another, in a “good vs. bad” context, is a false choice.  All our current sources are critical at present and will either grow in importance or at least remain significant for decades to come.  Renewables should and will become an ever-increasing portion of the energy pie, but even they will need cleaner technologies for what is currently a highly extractive and energy-intensive industry.  When considering businesses for an investment portfolio designed for long-term compounding, it is hard to imagine an industry with greater general long-term prospects than the energy sector.  While there may be disruptors to a given technology, there will always be a need for power, and that need will grow.  What remains constant from an investment standpoint is the search for the highest-quality businesses in any sector.  In this case, that means selecting from among those engaged in developing, producing, distributing, and servicing energy sources of all kinds.