While ESG (environmental, social and governance) mandates on pension fund managers, sovereign wealth fund managers, and other institutional investors are on the rise, these managers are still in the business of making compelling returns on their assets. Thus, it’s been notable that over the past few years, the trend within such investors’ private equity allocations has been to get out of oil and gas. A “Great Energy Shift” has been underway.
As a December report by Ernst & Young stated:
“As we approach 2022, it is increasingly clear that next year — and potentially the next five — in the oil and gas industry will be defined by capital markets’ reluctance to invest in oil and gas and the dissonance among government, consumer and investor perceptions about the speed with which oil and gas should or can be replaced and the very real inertias that will slow that transition.”
This is one reason why so many previously oil & gas focused private equity managers have been loudly shifting to “energy transition” strategies — in response to what their institutional investor backers have been asking for. However, thanks to the global economic recovery, this macro-level pullback in oil and gas extraction investing, and now geopolitical upheaval, oil prices are now up substantially from where they were 12 months ago. Owning upstream oil and gas assets at this moment is much more profitable than it was not too long ago.
So if you are a returns-focused institutional investor, is it time to jump back into oil and gas private equity in a big way? There are three reasons why the answer for many will be “no”.
First of all, large pension funds et al are not particularly known for being quick to change strategies, nor does the private equity model enable doing so — there are months if not years-long lagtimes between making a commitment to a PE firm and seeing the capital actually flow into investments. Furthermore, for many the shift away from oil and gas is part of a serious ESG mandate that will be organizationally difficult to back away from. So institutional investors aren’t in a position to change their approach to this sector on a whim.
If anything, for a large portion of the institutional investor community this high price market for oil and gas might represent an opportunity to accelerate getting out of the sector rather than jumping back in. I know several endowment managers, for example, who have been slowly transitioning out of fossil fuel holdings rather than take a bath in a quick “fire sale” of those assets all at once. Just as happened with Canadian energy companies six months ago, such endowment managers and even larger institutional investors with already-established goals to transition out of oil & gas may be seeing this as an opportunity to sell high.
Secondly, price spikes in a commodity sector may make it more attractive in the very near term, but it also highlights volatility in that sector, and for many institutional investors they’re not in the energy infrastructure sector to chase volatility. To overgeneralize, infrastructure investors are less prone to embrace volatility than other asset categories will. Fossil fuel infrastructure has always been seen as near-term volatile because of the merchant nature of most offtake (ie: they sell into commodity priced markets), and now are increasingly seen as risky in the long term as well, thanks to the climate change megatrend. Whereas renewable energy projects can often have firmer or at least more predictable costs and revenues, driving many conservative investors to shift their infrastructure allocations into these areas instead.
“Buying into operating wind and solar assets has become so low-risk in certain markets that the more conservative financial investors, such as pension funds and insurance companies, have moved in en masse.”
In short, over the past half-decade, perceptions of oil and gas as the “safe choice” and renewables as the “risky option” have flip-flopped for institutional investors. This is what’s really behind the “Great Energy Shift” among such investors. And seeing oil price volatility more than double over the past five years isn’t going to change these perceptions.
Third, beyond ESG mandates, institutional investors have to worry about their “right to operate” with a long view. Some oil and gas proponents are predictably using this geopolitically fraught moment to advocate for more “Drill, Baby, Drill” incentives in the U.S. But many other voices are rightfully pointing out that Russia’s invasion of Ukraine is being fueled by oil and gas revenues, and that encouraging more drilling for oil in the United States for the sake of lowering global prices and thus hurting Russia’s earnings, would in actuality be neither timely nor effective — it takes months if not years for new incentives to result in any new wells being drilled, and oil is a fungible commodity anyway so more drilling in the U.S. does very little to reduce global oil prices except on the margins.
After all, after decades of incentivizing shale oil production, the U.S. has now achieved what some pundits call “energy independence” — net-positive exports of oil and gas. And yet our domestic gasoline prices are as high as ever. Maybe just maybe being a net exporter of a global commodity like oil doesn’t actually equate to economic “independence” from price volatility in those markets. And meanwhile, Russia (which gets around half of its export revenues from oil and gas) is propped up in their international aggression because every time they cause oil prices to spike by creating geopolitical turmoil, they themselves enjoy the benefits of those higher prices. No, increasing domestic oil and gas production wouldn’t be nearly as effective in undermining Russia’s ability to fight wars, as would reducing demand for oil and gas in the first place.
If you care about helping Ukraine, if you want to help reduce the incentives for petrodictators to warmonger in general, and if you want to strengthen national security for the U.S. overall, the clearly more effective approach would be to accelerate the transition away from oil and gas into renewables and energy efficiency. Not to encourage even more oil and gas dependency by boosting the supply of those commodities. The economic logic is obvious.
And institutional investors, with their long-term view, recognize this as well as anyone. Not only to reduce their own sectoral risk exposure, but also to reduce their political exposure. Thus we can expect that many will be reticent to court criticism by reversing course and jumping back into oil and gas private equity at this moment.
So for these reasons, I do not expect we will see sudden reversals and en masse shifts by institutional capital back into oil and gas private equity. However, we will see some of this on the margins. For example, private equity managers with on foot in each of fossil energy and renewables may be able to make effective fundraising pitches around their ability to flexibly pivot into and out of fossil fuels even as their institutional backers cannot. This price spike in oil probably increases the relative attractiveness of “energy transition funds” for pension fund managers for this reason.
But “The Great Energy Shift” by institutional investors, out of fossil fuels and into renewables, is now well underway and will not be quickly reversed. After all, even coal miners are now getting into renewables. Institutional investors have turned the page, and they’re not going back.
