Opinion - Powering the Future

Energy markets are in transition, and investors are retreating. Here's why

Daniel Yergin and Carlos Pascual, IHS Markit
Key Points
  • IHS Markit interviewed institutional and private equity investors with a total of $98 billion in energy assets under management to assess their attitudes on energy investing.
  • It revealed that investors have retreated from investing in energy stocks because of the sector's underperformance due to commodity price volatility, low return on invested capital and long-term supply-demand imbalances.
  • Sixty-three percent of respondents agree that the oil and gas sector is currently undervalued.
Roger Milley | E+ | Getty Images

While the stock market has boomed, energy stocks have not. Indeed, they have been the worst-performing sector over the last decade. Moreover, energy has dropped from 15% in 1990 to only 5% of the S&P 500 sector weightings in 2019. This is particularly ironic, since U.S. oil and gas production has boomed over the same period, making the United States the world's largest producer of oil and gas — and making the country virtually self-sufficient.

Why the retreat from the energy sector? Is it because of poor economic performance by companies themselves, compared to the overall market and other sectors, such as Big Tech? After all, this 10-year period encompasses the 2014–2016 oil price collapse. Or is it because of the growing impact and scale of ESG (environmental, social and governance) investing?

To answer the "why," IHS Markit Corporate Solutions' Investment Perception group recently completed in-depth interviews with institutional and private equity investors with a total of $98 billion of energy assets under management, a population that encompasses focused energy investors, generalist portfolio managers and large multinational PE firms. The methodology is that which IHS Markit applies for companies to assess sentiment among investors.

The results come to the clear conclusion that economic performance is significantly more important than ESG considerations at this time. But the survey also finds that ESG and climate are weighing on overall investment attractiveness of the energy sector and will continue to grow in importance.

The investors identify commodity price volatility, low return on invested capital and long-term supply-demand imbalances as the main factors that lead to investment underperformance historically. As one of the respondents puts it, "There is a general apathy towards the sector as a result of not having made money over a one-, three- or five-year period. Investors have really pushed for a conversion into a more returns-based model, where they can get real visibility over what kind of cash flow they can look at."

Still, 67% of respondents believe that there is potential for the industry to experience a cyclical reversion in the stock market and come back into favor with equity investors. They believe that a rotation back into the energy sector is contingent on the supply-demand balance, conservative capital strategies and an improving outlook for the global macro and trade tensions.

Sixty-three percent of respondents agree that the oil and gas sector is currently undervalued. A minor portion of respondents, who are less optimistic, believe that current valuations are fair when considering their outlook for commodity prices and long-term uncertainty around terminal values.

67% of respondents believe that there is potential for the industry to experience a cyclical reversion in the stock market and come back into favor with equity investors.

One respondent observes: "When we see capital flight out of the sector [departing] from the long-term fundamentals of demand. ... we see it as a good time to invest."

Investor views on climate change

Investors underscore that even though climate change is not a direct driver of their investment decisions, addressing ESG concerns is critical to address public pressure and reduce risk.

In the words of a major North American private equity firm: "Companies need to focus on articulating their story [on climate] to demonstrate what they are doing. Being good stewards from an ESG standpoint is risk-reducing. It is not just about being a good citizen but also about making your business better."

Also striking are investor views on investment potential and returns on renewable energy.

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A 'sense of dread' in oil markets isn't going to 'dissipate quickly,' says IHS Markit

When considering companies that diversify into clean tech and zero- or low-carbon initiatives, most investors base their view on the merits. They foremost look at the return profile of the investment compared to other uses of capital. Second, they weigh the strategic rationale and core competencies of the business to determine whether it will create meaningful value.

Approximately half of the study population has experienced investing in renewables. Regardless of their involvement, nearly all institutional investors state there are not sufficient investable companies for them to invest at scale. Many participants said that the return profile of renewable companies has been subpar. Only a few investors cite success investing in the space, noting the importance of selectivity and timing.

Looking ahead, investors cite uncertainty around the energy transition — about future supply and demand, the onset of peak demand, developments in the Middle East, the U.S. elections and related political and security dynamics — as affecting investment decisions. When asked whether greater certainty about the timeline of energy transition would benefit investor interest, 72% of respondents said it would help them value assets with greater conviction.

Still, challenging as these issues on politics, regulation, investment and technology might be, investors see potential rising value in oil and gas and renewed interest in the industry. Under any assumption, the world will continue to demand fossil fuels for decades. As one North American mutual fund with more than $1 billion in energy assets stated: "ESG is an important thing, but I am not going to abandon the oil and gas sector. ... We still need these commodities, and these companies just need to do the best they can to reduce their impact on the environment."

—By Daniel Yergin, vice chairman of IHS Markit and author of "The Prize" and "The Quest," and Carlos Pascual, IHS Markit senior vice president for global energy and international affairs

NOTE: Qian Chen contributed to this article. She is a director on the Investment Perceptions team within IHS Markit's Corporate Solutions group.