Where have we come from, and where are we going?
After “Why are we here?” those are probably two of the most challenging questions anyone has ever put out there. Unfortunately, I can’t say I have the answers, but a book I recently read takes a sweeping and entertaining look at the history of humans, providing some thought-provoking insight into the past and the future.
Sapiens: A Brief History of Humankind by Yuval Noah Harari integrates history and science to explain and challenge pretty much everything. In looking back, Harari describes the forces that have shaped human society and postulates what we can do to influence the course of centuries to come.
That said, Harari admits that the future is unknown and he’d be surprised if his forecasts are fully realized. Still, by looking back, we may indeed glimpse the future. One example he cites: We can safely assume economic growth requires energy and raw materials, and we know that these are finite. “But the evidence provided by the past is that they are finite only in theory. Counterintuitively, while humankind’s use of energy and raw materials has mushroomed in the last few centuries, the amounts available have actually increased.”
Our sources of energy started simply—fire was discovered to heat. And then we learned about conversion—fire under a kettle produced steam. In viewing our human condition through that lens, while resources may be finite, human ingenuity so far has seemed infinite.
And in a compelling way, I feel this is the situation in which global energy producers now find themselves.
It’s no secret that lower oil prices and the prospect of a diminishing demand for fossil fuels are prompting a serious rethinking by energy companies. Such trends may be amplified for oil companies in Europe, where national governments are attempting to replace vehicles that use combustion engines with electric vehicles, thereby significantly cutting emissions and oil demand. Given larger concerns about local air pollution and climate change, some or all of these steps may be justified.
Environmental concerns about the consumption of energy are of course nothing new. But what's changed in the last few years is the maturation of new and arguably more sustainable energy sources that can be used to power our lives. Evident for a while, wind and solar stand poised to reshape energy markets. And as we see the world begin to transition from a hydrocarbon-dominated system to one where renewables are beginning to build an influential market share, the serious players in energy will seek to leverage all technologies available—from established to upstart.
By that I mean that energy companies will need expertise, balance, and optionality to hedge against any potential future erosion of their upstream value proposition and the hardening of investor sentiment toward carbon energy sources.
So, what’s the optimal strategy? As the energy market struggles to come to grips with renewables and the uncertain timing of transition, the clock is ticking. Such uncertainty may make it difficult to decide how to allocate capital in the near term. Energy companies will likely strike a balance between maintaining their core businesses in oil and gas while keeping their options open in alternative energy.
In my thinking, five key factors will influence energy strategies:
Exploiting oil and gas synergies: Biofuels, rather than wind and solar, have arguably the greatest synergies with traditional liquid fuels businesses. In contrast, the majority of growth in wind and solar will be in the power sector, which has very different characteristics to oil and gas markets. That said, there are synergies between gas and renewables, both of which supply the power sector. But offshore wind fits most naturally into oil companies’ core competencies. It has a long-term time horizon, is more capital-intensive, and requires technical, engineering, and project management skills, which means that barriers to entry are higher.
Leveraging legacy geographies: The North Sea has seen considerable offshore wind development and is a prime target for further development in the near term, favoring some European companies. But operators will also have to look farther afield for offshore wind projects that offer scale and portfolio diversification. Offshore, the United States, Brazil, Algeria, and Asia (China, Japan, South Korea, India) all have potential. In solar, we expect companies to focus on emerging markets that lack an established group of local players or in which they already have well-established relationships and infrastructure. These include the Middle East (Kuwait, Oman), North Africa (Algeria, Morocco), Latin America (Chile), and Asia (India, Australia).
Focusing on organic growth versus M&A: Organic-led growth is likely to be the preferred growth option in offshore wind. There will also be farm-in opportunities as developers look to attract financially strong providers of capital for new projects. M&A could play a role in expanding into the solar sector. There’s no shortage of stand-alone companies to rapidly establish critical mass, and there will be farm-in opportunities here as well. But competition is intense and the market fragmented. My sense is that companies are still struggling to justify valuations and understand where they want to participate in the value chain. We expect growth to be measured in the near term.
Improving risk/reward balance: Several factors—larger wind turbines, economies of scale in the supply chain, digitalization, greater efficiencies, deployment of learnings, and repeatable manufacturing style processes—will drive improved economics over time. This should allow wind and solar to compete on a level playing field, increasingly without subsidies but still generating utility-like returns. Paradoxically, a structural long-term decline in oil and gas prices would increase the rate of renewables penetration. The conventional wisdom is that high oil prices foster disruptive technology, but low oil prices marginalize more upstream investments as renewables costs fall.
Keeping technology options open: Wind and solar are the early winners in the 21st century, but technology can change abruptly. There’s a real danger of backing the wrong horse in this immature market. Could carbon capture and storage (CCS) technology ultimately trump wind and solar, creating a level playing field for fossil fuels? Energy companies will hedge their bets by injecting seed capital into investor capital funds to incubate early-stage options in renewables, battery technology, and CCS.
For the short-term outlook, we know that oil and natural gas will continue to provide the lion’s share of the world’s energy demands. But I believe there could be an uplifting effect on investment returns as wind and solar begin to generate stable cash flow and earnings—an especially good thing if oil and gas prices come under further pressure.
Early movers in the renewables arena can establish a track record and gain a competitive advantage in finding further opportunities as these technologies are refined. Players that embrace solar, wind, and alternative sources of energy may find, perhaps counterintuitively (to use Harari’s word again), that they just may come out on top of the most massive shift in energy production strategy that we’ve seen in generations.
