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The Next Generation of Commodity Returns

By Caroline Abramo

Introduction

Today’s oil and gas sectors are considered mature businesses with understood returns, cash flow characteristics and risks. The economic profile of new low – carbon businesses and how they will develop in the future is less understood. In this article, we will assess the return characteristics of these businesses as they exist today to better understand what role they can play in portfolios beyond just satisfying stakeholder demands for lower carbon businesses.

Opportunities in the Energy Sector

As the U.S transitions from the Industrial Age of the last 200 years to the Digital Age of the foreseeable future, we have an unprecedented opportunity to bring climate, sustainability and cost efficiencies to all of our commodity supply chains. These categories, most notably energy, have been mainstays in portfolios for decades. While they have traditionally delivered high returns, they have also been among the largest CO2 emitters.

Drawdown Project has shown a clear path to reaching the Paris Accord goals through technologies geared toward these sectors. Here’s a peak at how carbon impact breaks down by sector:

When investors think of transition, they likely think of renewable energy (solar, wind) which have a robust return history and clear path from an incentive and technology basis. Incentives foster more technology and lower costs, letting incentives phase out. This happened in solar and wind over the last two decades where returns started at over 20% but are now more consistent with 7% as they have been de-risked.

Their role in power generation is central but limited, never provide more than 50% of power needs given their intermittent quality. They only work when it’s sunny or windy and require a lot of open land (where people generally are not).

Today, there is a heavy emphasis on battery storage and technology (which is also central to EVs). Grid stability and distribution are other key areas that will continue to bring costs down and sustainability high.

The Other 50% of power generation

We cannot ignore the other 50% of power generation which are fossil fuel – driven. Key focus areas include:

  • Carbon Capture and repurposing in the Fossil Fuel extraction process
  • Technologies to de-sulfur our transportation fleets
  • Downstream derivatives of energy like chemicals and plastics
  • Big users of energy like agriculture and industrial processes

There are many regulatory incentives already in place at a Federal level as well as from a state perspective. California has taken leadership on with eleven other states looking to follow. Drawdown points to key areas of technology needed for the next generation on wind and solar.

Here’s how Drawdown categorizes the next generation of opportunities:

Financial Returns

Overall, the oil and gas sector has tended to generate some of the highest returns over the last decade among these industries. The sector has delivered median annual operating ROIC (Return on Invested Capital) during this time of 8.5%, including a peak of 14.4% in 2012 (significantly lower since 2014, following the oil price collapse and down sharply from the median of 21.8% from 2000-2009. Renewable fuels have returned 9% since 2010. (SOURCE: IHS Markets)

These returns have come with the highest volatility of any sector due to the volatile nature of the commodity cycle.

A key benefit of a new group of energy strategies is that they are not correlated with energy prices – WTI and natural gas. Pana LCE’s key sectors have both return uplift and diversification benefits for the entire portfolio, lowering total volatility, and all of the Pana LCE sectors have low correlations with oil and gas.

In addition to a risk management benefit these sectors can deliver a green “premium” in the form of value to corporations that want to “green” their supply chains and products. The need to do this is not only driven by regulation, but by consumer demand to buy products that meet LCE or carbon-free guidelines. This is similar to what we have already seen in food products. Consumers are willing to pay a premium for vegan, gluten-free, carbon-free, plastic-free, etc., although the cost has decreased materially in the last several decades through private and public funding in technology. Equally important is that the green premium is being realized in real stockholder value. The companies that are sustainable and green will endure, delivering more consistent financial results over time.