The price of West Texas Intermediate crude oil has just had its largest two-year gain in more than 40 years. The contract price that fell to minus US$40 per barrel at the start of the COVID-19 pandemic, has recently traded up to as high as US$130 per barrel and is now sitting at around $100 per barrel [in mid-March 2022].

So, how have oil shares performed in this five-fold price rise from US$20 to US$100 per barrel, and how can you decide if you want oil company exposure in a portfolio?

Key drivers for changing oil prices

The oil industry is complex and requires large amounts of capital to develop highly technical projects that are capable of producing oil and gas for longer than 20 years. Low-cost production and efficient operations can form the economic base for many large oil-producing companies as well as countries. 

In addition to production and operational costs, there are several interlinked factors when considering oil prices:

1. Oil price influences valuations. The valuation of oil companies can be highly influenced by the oil price. Oil shares, when compared against other global equities, have underperformed since around 2010. This can be partially explained by the fact that as the long-term prospects for the oil industry become more constrained, the amount that investors are prepared to pay will likely decline. 
   
   
2. Forward prices vs spot prices. If you dial into the finance segment at the end of the evening news, you may hear commentators talk about “spot prices” and “forward prices” for various commodities, including oil. Simply, a spot price is the price that oil can be bought or sold for today, for immediate delivery. While the forward price is an agreed upon price for future delivery. That forward price looks beyond the spot price and reveals the current market view of the longer-term price.
   
   
3. Location. Knowing where oil trades is important. The market is often reluctant to price in high spot prices, knowing that the organisation known as “OPEC+” has restrained production. When oil prices are high, it means that higher cost producers such as US shale oil, or Canadian oil sands, can significantly increase their production, knowing that higher prices will cover their relatively higher production costs. 
   
   
4. Geopolitical factors. The current commodity market price gains connected to Russia’s invasion of Ukraine, along with sanctions and disruption to global trade, have also added to the volatility of oil prices recently.
   

Role of climate change

Other key considerations for the oil and gas industry are:

• growth through new exploration and development;
• strategic acquisitions made at the right time and price;
  
• a sound shareholder base;
  
• capable and motivated management and operating teams of these companies; and
  
• the increasing urgency surrounding climate change.
  

Climate change has caused a seismic shift for the oil and gas sector, given that the production and burning of fossil fuels are major sources of greenhouse gas. 

Companies in the oil and gas sector now face major opposition as they will need to cease production or fully mitigate that damage. Both paths are extremely disruptive and will be expensive to shareholders of these companies, in Janus Henderson’s view.

As renewable electrification of the global economy grows to displace fossil fuels in areas of power generation and in vehicles, it is highly conceivable that the demand for oil will fall by more than fifty percent.
 

Waning influence of oil and gas – an opportunity?

There is increasing pressure on the oil and gas sector to scale back growth expectations. This would include spending less on exploration, which is the life blood of the industry and a source of value in the past.

The fossil fuel sector is looking to adjust its business model in the face of a global need to decarbonise, at a time where the possibility of cheaper wind and solar renewable opportunities abound. Do oil and gas companies continue with “business as normal” in the hope that renewables will not deliver? Or do they adapt and become a force in renewables themselves? 

Woodside Petroleum (ASX: WPL) has merged with BHP Group’s (ASX: BHP) petroleum business and whilst it will continue to be driven by oil and gas for the next 5-10 years in Janus Henderson’s view, it is also clear that the business is examining alternatives such as hydrogen.

These changing business models create uncertainty surrounding the closure, and cost of remediation, of production wells. This is likely to be expensive, especially in deep offshore locations. Some companies will choose to merge.

This waning of influence will be reflected in the industry not attracting the large-scale capital that was once a given. Instead, this capital is likely to be redirected into renewable energy such as solar and wind, and over time, most likely into hydrogen produced from the electrolysis of water made possible by cheap renewable energy. This is referred to as ‘green hydrogen’ and today it is very much in its infancy. 

Strong levels of demand can only be expected as the costs of green hydrogen are reduced, nonetheless, some companies are at the forefront of determining how the hydrogen market will play out. 

Interestingly, this includes the global industrial gas sector, which has had generations of experience in the safe production, transport and use of hydrogen produced from fossil fuels. These companies are expected to be leaders in the next generation of green hydrogen. 

Between times, they are likely to be involved in Carbon Capture Utilisation and Storage (CCUS). This would be something of a transition step – when hydrogen is produced from natural gas, CO2 is emitted as a waste gas. This gas can be economically collected and then transported to deep underground reservoirs for permanent storage. 

The US government already has subsidies in place to help encourage this transitional step and increased subsidies are expected under US President Joe Biden’s “Build Back Better” program. While controversial, Janus Henderson expects this to be an important step as the world continually decarbonises.

What about going global with energy investing via a fund?

Investment opportunities are starting to appear for those looking to invest in global companies that can help the world to decarbonise. At Janus Henderson, we run a Net Zero Transition Resources fund* made up of just those types of companies. 

Janus Henderson's view is that the companies we invest in must meet a set of stringent guidelines, including an expectation that they are well run businesses, with sensible debt levels, have low costs or strong margins by virtue of premiumisation of revenues, and that they are ESG-aware (Environmental, Social and Governance), including being transparent and having strong and improving relationships with stakeholders. 

Most important, companies must have an ability to enable and contribute to the decarbonisation of the planet. For this reason, companies from the oil and gas sector are excluded, as are gold companies, since, in the view of Janus Henderson, gold will not play a fundamental role in helping enable the move to decarbonisation.

Instead, Janus Henderson see broad investment opportunities in the likes of:

• raw materials that underpin the production of electric vehicle batteries (such as copper, lithium and nickel);
• raw materials used for lightweight vehicles (such as aluminium) or steel used in the manufacture and installation of wind farms;
  
• the renewables sector itself, including hydro, wind or solar; and
• green hydrogen to be used as a fuel source for heavy vehicles and a reducing agent for steel production.
  

Is the grass greener?

Investors might also consider a broader portfolio of investment opportunities in natural resources, including extending into agriculture. This includes:

• sustainable and regenerative agriculture that improves the sequestration of carbon in the ground;
• a gradual switch to alternative proteins to reduce the heavy reliance on the high carbon intensity beef industry; and
  
• extending to forestry, where the carbon is sequestered in the timberlands if harvest cycle times are extended.  
  

Lastly, but by no means least in the approach to helping the world transition to net zero by 2050, is the recognition that one of the best and most proactive means to decarbonise is to maximise the recycling of steel and aluminium products and the cardboard boxes used in packaging. 

The production from recycled materials translates into less energy usage and given that almost all that energy is fossil fuel based then significant carbon emissions can be avoided.
 

Where does that leave oil? 

The oil and gas sector is a dominant force in both developed and developing countries, and has been for some time. The infrastructure behind the sector is so immense that the sector is not going to disappear quickly. Janus Henderson would expect that there will be numerous cycles when super profits and cash flow result, and outright energy funds will continue to be available for investors.

However, Janus Henderson is looking forward. As the world makes the transition to decarbonise, Janus Henderson prefers those broad sectors where growth is much more apparent and the risks are more manageable. 

Janus Henderson strives to make strong returns by identifying companies that are alert to these opportunities and capable of executing on them while enabling and delivering on the low carbon transition.