Sustainable Alpha: The role of energy prices

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Jessica Wirth is an analyst and for Putnam Investments and portfolio manager of Putnam Global Energy Fund.

Sustainable Alpha features shared conversations with the best minds, portfolio managers and industry leaders working to maximize returns while prioritizing the environment, social and governance factors — what’s become short-handed in the industry as ESG. Sustainable Alpha highlights portfolio approaches and investment trends against the backdrop of broader themes such as resource constraints, policy changes and demographic shifts — all while shedding light on how ESG can impact your investments.

Sustainable Alpha conversations are led by John Wrenn, Senior VP, Investments for UBS. The Wrenn Ferguson Group has a combined experience of 200 years managing over 1.6 billion in assets, offering customized wealth management strategies for individuals, endowments and foundations. View the rest of his conversations with leaders in the sustainable investment community.

Here he's talking with Jessica Wirth, an analyst for Putnam Investments and a portfolio manager of the Putnam Global Energy Fund.

John Wrenn: Today 85 percent of the world's population lives in emerging markets. How will growth of emerging market economies impact the price of energy in the future?

Jessica Wirth: The growth of emerging market economies will underpin high energy prices, such as the ones we are seeing today, over the coming decades. Under the central forecast of the International Energy Agency, energy demand will increase by more than one-third from today to the year 2035. Of this growth, 90 percent will come from emerging countries, with China alone accounting for around one-third of the growth. While China has only recently (in 2009) surpassed the U.S. in overall energy consumption, the country is expected to consume 70 percent more energy than the U.S. in 2035. Even then, the Chinese will consume less than half the energy of their U.S. brethren, on a per-capita basis. Other emerging countries — India, Indonesia, Brazil, and the nations of the Middle East — will also continue to see demand increase at high rates.

We have begun to experience the impact of emerging economy-fueled demand growth on oil markets over the last few years, in the erosion of the available spare capacity cushion. This cushion represents the global oil market’s excess supply, or its ability to meet demand increases or mitigate supply disruptions. Against a backdrop of a stable global economy, this cushion now falls below 5 percent of demand — a level that does not provide abundant room for disruption or growth. While we expect supply to continue to grow — facilitated by advances in technology such as ultra-deepwater drilling and tight oil extraction — this cushion is likely to remain at a relatively tight level.

JW: Are geopolitical concerns in Middle-East going to keep oil and gas prices high at the pump?

Wirth: At the moment, it seems that way. The potential for oil supply disruptions has risen in recent months in lock-step with the array of geopolitical risks in the Middle East and Africa. Areas where we see varying degrees of oil supply disruption risk include: potential sanctions against Iran and potential interference by Iranians with transport through the Straits of Hormuz (through which 13 million of the world's 90 million barrels flow daily); ongoing instability in Yemen, Syria, and Sudan; the government transition underway in Egypt; increasingly violent sectarian strife in Iraq on the heels of U.S. withdrawal; and widespread unrest in Nigeria over the removal of domestic fuel subsidies.

On the flip-side, the return of production from Libya is progressing quite well, and will provide a needed offset to any supply disruption coming from this minefield of inter- and intra-country issues. In addition, while the aforementioned risks could induce supply shock-led increase in oil prices, we would expect any significant price spike to result in demand destruction, which would bring oil and gasoline prices back down.

JW: Are we making necessary investments in new technologies, energy efficiency and infrastructure to keep up with future demand?

Wirth: The pricing environment provides incentive to invest in technological advances and infrastructure expansions that should help the global energy market meet future demand. Much of this investment is taking place in the international market for natural gas. Because natural gas cannot be easily contained and transported across great distances, there are significant dislocations in pricing between the markets where supply is ample — such as U.S., Canada, Russia and Australia — and the markets where supply is short — such as China, Japan and India. Companies are investing in ways to transport natural gas from oversupplied to under-supplied markets. These multi-billion-dollar investments include the liquefaction of coal seam gas in Australia, the construction of pipelines across many thousands of meters of Russia into China, and the construction of gas liquefaction plants in the U.S. and Canada.

JW: How are energy companies investing in non-traditional or alternative clean energy sources?

Wirth: In varying degrees. At this point, several of the large-cap integrated oil companies are investing in early-stage developments in areas like solar modules (Total), lithium ion batteries (ExxonMobil) and wind power (Statoil) with the aim of staying in front of the research and development curve.

The rationale for these investments are generally twofold: (1) Energy companies realize that generating “green” energy supplies will ultimately serve as a hedge as global markets increasingly apply taxes to carbon emissions, and (2) Energy companies are looking to retain long-term market share as providers of energy from all sources, so they are securing a foothold in supply of lower-carbon fuels.

That said, the majority of the integrated oil companies’ capital expenditure budgets will remain focused on growing oil and gas supply, as the consensus view is that alternative energies will comprise less than 5 percent of global energy mix into the 2030 decade. In order for the demand for alternatives to exceed this level, the industry will need to see more long-term incentives and support from governments.

JW: How should investors be reacting to all the volatility in the markets created by price dislocations across the energy sector when thinking about the fund you manage?

Wirth: Investors in the energy space would be well-served to try on the thinking caps of the companies that are investing capital directly in the sector — the integrated oil, exploration and production, refining, drilling, and oilfield services companies. These companies are investing on multi-year, and sometimes multi-decade cycles, many with a long-term view of the global supply-demand framework, and a keen eye on the impact of emerging market economic growth. Within the industry, there are more defensive investment options that fall among the “multi-decade” investors (such as the integrated oil companies), and there are more pro-cyclical investment options, for whom the investment cycle takes a shorter turn (such as the oilfield services companies). Our fund looks to capitalize on opportunities created by price dislocations across these sectors whenever they occur, buying stocks of companies that look cheap relative to their bottoms up fundamentals, and avoiding stocks of companies that we feel the market has over-valued. Doing this successfully, we believe we should be able to find the outperformers in the energy sector through the cycle.