Oil old and new oil, and why green transformation leads to inflation
Head of Equity Strategy
Summary: Our commodity theme basket is the best performing theme so far in June driven by rising commodity prices. While rising oil prices have stolen attention lately we explain why investors should ignore the this rally in oil and gas majors. Instead we think investors should look long-term and bet on copper as it will become the new oil of our future greener society. Finally, we touch on the fact that the green transformation could become the single most important driver of future inflation.
We started the year with inflation being our big conviction and we have maintained that ever since. Part of this view is our overweight view on the commodity sector which is up by 25% this year driven by a boom in commodity prices with Brent Crude lately pushing above $71/brl.
The energy sector today is still dominated by “old oil” companies and we have recently got questions about whether to invest in this industry since the industry has become cheaper relative to the overall market. While it is true the energy sector has become cheaper against the overall equity market and the outlook has improved with the rollout of Covid-19 vaccinations, the overall energy sector is trading at 12-month forward EV/EBITDA of 6.5, which is above the average since 2005. This period includes many years of far better fundamentals in terms of return on capital than what the industry can generate today.
The problem with investing in the old energy sector is that it is essentially a bet on higher prices because the production volume will most likely be stagnant because of political pressures to end additional oil and gas exploration. Signs of the mounting pressures have been evident lately with Engine No. 1 winning three board seats and advocating for big strategic changes at ExxonMobil, the largest integrated oil and gas major in the developed world, in the direction of a greener future. In the Netherlands, the Dutch court has ordered Royal Dutch Shell to cut carbon emissions by 45% by 2030, which effectively mean no new oil and gas fields for the Dutch energy company; the energy company is expected to appeal the court decision.
The uncertainty facing the oil energy companies is too big and the oil price is still too low for the old energy industry to be at a sweet spot for long-term investors. We remain sceptical of oil and gas majors for now. But in the green energy industry the current sentiment is not good either. As we recently wrote the industry is undergoing a second collapse of expectations and equity value vs old energy companies. Orsted, the world’s largest owner and developer of offshore wind farms, recently communicated its new long-term financial goals which include a $57bn investment plan to remain the largest energy player in offshore wind and reach 50 GWh of installed capacity by 2030. Under this plan, Orsted expects to grow EBITDA annually by 12%, but the market is buying the growth prospects for now sending shares lower.
Copper is the new oil and why green transformation equals inflation
The “new oil” that will fuel the green transformation and electrification of our economy is copper, which is much more intensely used than in our old industrial economy. Commodity analysts are split on the demand-supply balance, but from an equity perspective it matters more long-term what the demand outlook is. Here it looks great due to the politically decided green transformation and our view is that investors should get exposure to copper over the coming decades as the value of this commodity will go up because of its importance during the electrification. The table below show some of the available copper miners in public markets.
Publicly listed copper miners
|Name||Market cap||EV/EBITDA||% to target|
|Southern Copper Corp||53,586||12.1||-7.7|
|First Quantum Minerals Ltd||16,850||10.5||16.4|
|Jiangxi Copper Co Ltd||11,470||NA||11.8|
|KGHM Polska Miedz SA||11,424||8.7||0.5|
|Lundin Mining Corp||7,869||7.5||26.3|
|OZ Minerals Ltd||6,708||16.3||-10.2|
|Turquoise Hill Resources Ltd||3,508||8.2||31.5|
Source: Bloomberg and Saxo Group
The CEO of BlackRock Larry Fink said yesterday that we could be facing an ‘inflation shock’ if we decide to move too aggressively on the green transformation. Our indecision for years on climate change has forced policy makers to adopt an aggressive path toward net-zero carbon which risks that the economy will hit a physical constraint creating inflation. The green transformation has the potential to create more permanent inflationary pressures and it will be discounted by the market and economists because the dynamics cannot be modelled on historical data as this is a paradigm shift decided politically. A copper miner such as Southern Copper said on their Q1 earnings call that existing mines can be expanded but their next new two mines will not begin operation until 2024 and 2027. This provides insight into how cumbersome it is to expand supply in the physical world unlike the “infinite” expansion of supply we have gotten used to in the digital economy.
The green transformation is also driving the new EU carbon border tax, which is a natural extension of the green agenda. The EU cannot be green without losing manufacturing jobs if imported goods from polluting countries are not taxed on its carbon footprint. Effectively the political ideas of the green transformation and nationalism will converge over the coming years. These forces will underpin higher production costs and prices in general.