Global Energy: Positioning for the Long Term
A long-term orientation allows us to move from today’s headlines to tomorrow’s prospects. While current energy headlines are focused on OPEC’s ability to accelerate the rebalancing process, we are focused on two longer-term developments that are influencing our positioning in the energy sector. First, the leaders of the domestic exploration and production (E&P) industry have already adapted to lower prices and are ready to accelerate capital investment (see Global Energy: Adapting to New Realities August 2015). Second, momentum behind electric vehicles is increasing and new battery technologies have the potential to erode oil’s monopoly position in the transportation sector. In this Industry Perspective, we will explore developments underway in the transportation sector that may lead future oil demand to differ from the “business-as-usual” expectations presently imbedded in the oil industry.
An Evolving Transportation Sector
Currently, oil is central to our transportation system due to its superior energy density and logistical advantages over alternative energy sources. Equally, the transportation sector is vital to oil prospects as it generates over 60% of global oil demand and contributed 80% of cumulative growth in demand since 2000. However, over the past few years, a number of new trends have developed that are capable of reshaping oil’s role in the transportation sector. Individually, each trend is significant, but we believe the combined impact could prove transformational – at least to many industry projections for oil demand. It is important to take a long-term integrated perspective of the individual developments underway as there could be a powerful dynamic of mutual reinforcement at work.
At a high level, global fuel economy regulations are forcing substantial changes to automobile engine designs. In order to comply with stricter standards, automakers are downsizing gasoline engines, incorporating turbochargers and/or connecting electric motors to form more efficient drivetrains without compromising performance. These changes add incremental costs to internal combustion engines and help to make electric vehicles cost-competitive alternatives in the mass market.
Additionally, recent rapid improvements in battery technology have been key in overcoming electric vehicles’ main hurdles of short driving range and high upfront cost. Data from the U.S. Department of Energy (DOE) shows that battery costs dropped by 73% from $1,000 per kWh1 in 2008 to $268 per kWh in 2015. Ambitious targets for further improvements in battery costs and energy density are also in place. By 2022, the DOE expects battery costs to reach $125 per kWh – a level widely viewed as the crossover point at which electric vehicles become cost-competitive with internal combustion vehicles. In anticipation, major automakers like Volkswagen, Ford, Mercedes-Benz, and BMW have all recently shifted and expanded research and development efforts toward electric vehicles. Growing competitive pressures, and consequent technological innovation, hold the potential to significantly expand the appeal of electric vehicles in the mass market.
Emerging markets sit at the nexus of multiple trends impacting oil and automobile markets. Since 2000, emerging market countries generated approximately 90% of the overall growth in oil demand within the transportation sector. The dominant demand-side narrative has been that a rapidly growing middle-class population will continue to drive strong oil demand for decades. However, major cities in China and India are facing severe congestion, affordability, and environmental challenges on the back of rapid economic growth. A more sustainable alternative path may be needed and increasing urbanization levels provide the catalyst for change. New business models, such as Uber and Didi Chuxing, were unheard of five years ago but have already influenced mobility preferences in major cities. Further innovations in shared mobility and autonomous driving are on the horizon. We believe these advancements are very likely to be integrated with electric vehicles to create a powerful alternative mobility system. Given the circumstances, there is a growing possibility that China will leapfrog most developed economies in the adoption of electric vehicles. This could have profound implications for oil markets.
The oil industry has long operated under the principle that it will have difficulty meeting future oil demand. Unsurprisingly, many major oil producers continue to plan for a business-as-usual case in demand growth. Their long-range projections implicitly assume that the automobile industry will remain fundamentally similar in the years to come. However, the automobile industry is investing in electric vehicles in anticipation that its own future will be radically different.
Financial projections are often based on a straight-line extrapolation of historical trends. This can lead to a built-in bias that the future will repeat the past. There can also be an inherent tendency to remain behind the curve on factors undergoing exponential change as non-linear changes in trends are difficult to model. However, the lack of precision should not dissuade us from contemplating risks and opportunities that deviate from conventional thinking.
The domestic coal industry is an example of the value destruction that can occur when optimistic industry projections of demand continue to drive corporate strategy despite early market signals to the contrary. It demonstrates the reluctance of incumbents to accept a scenario other than growth, creating a need for investors to think independently, longer term, and to challenge conventional corporate assumptions.
Long-Term Risks and Positioning
Imagining the future as a spectrum of probabilistic outcomes can be a valuable exercise. There are many factors – technological, political, and economic – that can reshape the trajectory for oil demand. We remain alert to the possibility that the future trend in oil demand can change and probably will change at some point. We are also cautious that further improvements in engine and battery technologies, even if slow to penetrate into the marketplace, could change expectations and the behavior of key decision-makers throughout the oil industry.
Investing is about managing risk and uncertainty. Ultimately, the price paid for an investment is the best form of risk control and is a factor we solely determine. The history of the industry shows that investors are easily fascinated by the prospect of short-term upside. When times are good, it can be easy to lose sight of downside risks. The current low interest rate environment has introduced a new dimension as it appears more risk is being tolerated given the abundance of capital looking for return. However, an overlooked or tolerated risk is very different from an eliminated risk. Our long-term framework informs us that investing in a commodity with monopoly-like characteristics is fundamentally different from one facing a growing threat of substitutes.
We apply the same fundamental views across equity and credit markets in our search for attractively priced investments. We have been much less active in equity markets than anticipated heading into the industry downturn, and our equity portfolio exposure to the energy sector has generally declined over the past year. In contrast, we found compelling value and made several investments in credit markets earlier this year which significantly increased our fixed income portfolio exposure. Instead of attempting to time commodity price cycles, we believe it is most prudent to concentrate on finding attractively priced investments that we believe will be resilient at a lower commodity price, providing the margin of safety needed amidst a challenging sector backdrop.
1kWh = Kilowatt Hour
As of October 31, 2016, Diamond Hill owned equity and debt positions in Ford Motor Co. (F) and debt positions in BMW and Daimler AG.
Originally published on November 16, 2016
The views expressed are those of the research analyst as of November 2016, are subject to change, and may differ from the views of other research analysts, portfolio managers or the firm as a whole. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice.