The Allocators’ View: Energy Investing
Jagdeep Singh Bachher and Amy Myers Jaffe of the University of California argue that allocators should acknowledge structural energy market changes — and move beyond traditional middlemen.
In recent years institutional investors have dominated the flow of funds into commodity-related investments. It’s easy to see why: During their super-cycle of the 2000s, commodities — especially oil — were an endless glass of return. Pension funds, especially, placed big bets on oil and gas real assets, goosing up overall return for a decade and propelling what became the giant — albeit highly leveraged — shale industry in the U.S.
Then, in 2015, gravity hit.
Portfolio managers are now painfully writing down losses from prior oil and gas buying sprees, with caveats in their board reporting that oil is a cyclical industry and therefore valuation might recover. Indeed, it is never a good idea to bet against cyclicality or volatility in oil, and late last year a production cut deal by OPEC brought some relief to the sector. But regardless of whether the Trump administration makes good on its promise to cancel what it labels job-killing climate-change policies, investors would be wise to reevaluate why they hold oil and gas assets in the first place — and whether those reasons are still valid.
One thing is certain: We are seeing in the energy markets structural changes that go beyond typical cyclical swings. For one, the rapid pace of technological change will require new approaches to energy investing — seen most readily in the U.S. shale industry.
The shale revolution is undoubtedly challenging the concept that oil and gas depletion (remember peak oil?) is right around the corner. In prior decades theories about imminent reserve depletion provided a hall pass for any short-term commodity losses: Assets might be temporarily illiquid, the argument went, but they would certainly appreciate over time. But now, as the oil industry develops advanced technologies that can readily produce oil from source rock and carbon asset risk looms larger on the long-term horizon, a possibility has emerged that oil and gas reserves still under the ground might depreciate — or even become stranded in the long run — rather than appreciate.
But there is a second concern as well. The massive borrowing of the shale industry is increasingly linking oil commodity prices and financial markets. Back in the early 1990s, oil commodity prices and the stock market traded inversely, making oil assets a great diversifier. Even in the late 1990s and early 2000s, the two markets were relatively uncorrelated. But in recent years contagion has set in, transmitting itself directly not only to the high-yield bond market, but also to the S&P 500.
In other words, rather than being diversified, real asset investors who are overweighted oil and gas are taking on substantial correlated risk.
To the extent that oil and gas upstream assets will remain attractive, preference will likely be given to reserves and properties that are deemed to be fully discounted for future uncertainties and stress tested for revenue generation based on relatively low long-term commodity prices. Since the risks of holding oil and gas assets is now perceived as higher, investors will favor resource assets and deal structures that provide cash flow and return faster, rather than count on a long-run appreciation strategy to counter commodity price risk.
But while we still see profitable opportunities in the oil and gas space, we believe a new approach to energy investing is needed — one that acknowledges the long-term transition in energy markets.
This is not based on a moral argument about the dangers of climate change. Rather, it is a financially driven analysis of the realities of real assets investing in a low-return, highly correlated ecosystem. If one is going to invest in energy, new market conditions mean that a much more nuanced view must dominate.
CIOs will want to consider a mix of different kinds of energy assets and in varying locations, increasing the proportion of lower carbon holdings over time. Rather than make the blanket assertion that certain kinds of assets will be deemed “uninvestables,” CIOs must consider the location of the asset, how the regulatory environment will treat competing fuel sources, and what the growth and export profile is for specific geographies and asset life.
Structures also matter. Various financial vehicles are being created to facilitate pension fund investment in renewable energy infrastructure and in clean-tech startups. A promising example is the Aligned Intermediary, an investment advisory group that helps long-term investors such as pension funds, family offices, and endowments identify investable climate infrastructure projects in clean energy, water infrastructure, and waste-to-value. The Aligned Intermediary operates at cost as a public benefits corporation to ensure its goals are aligned with its member entities, which currently include the UC Regents, the New Zealand Superannuation Fund, TIAA Global Asset Management, the Ontario Public Service Employees Union Trust, the Wellcome Trust, and the Church Commissioners of England. By eliminating the traditional fee structure for the entity, the Aligned Intermediary provides the same services of sourcing, screening, and structuring transactions and providing a risk-adjusted financial rate of return for direct debt and equity real assets investments, but has the same incentives and long-term goals as the underlying asset owners.
Stacked vehicles are another way to create a project pipeline and deal flow in the clean-tech space: Staggered or simultaneous seed investment fund vehicles provide another structure to deploy institutional capital, especially when tied to academia and national labs. In the case of our work from the University of California, access to early-stage companies spinning out of the UC system enhances such a structure and increases the opportunity set of knowledge and resources.
Regardless of financial vehicle structures, the clean-tech space remains littered with failed ventures — just look at the dismal experience of venture capital in biofuels investing. That is why stacked financing structures — ones that tap into academic institutions and accelerators, partnering corporations with experience in scale-up — can provide institutional investors with the comfort and ability to place long-term bets in the clean energy space. This, combined with collaboration and a more nuanced view of the underlying investments, is key to successful energy investing for allocators.