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Special report

The delicate balance of investing in energy

Renewable sources take forefront, but fossil-fuel investment not fading

Like it or not, oil and gas prices have a powerful impact on investors' portfolios — and not just on energy investments.

Fossil-fuel prices touch most asset classes: The price of oil and gas figures into the calculus of investing in everything from warehouses to the profitability of a manufacturer.

Overall, commodity prices are an area of diligence for investors and consultants when deciding whether to add a manager, said Adam Bragar, investment consultant, Willis Towers Watson PLC, New York.

This is especially the case for the pension plans of companies whose profits are tied to energy prices, such as transportation-related companies.

“You don't want to add additional exposure to energy prices” to pension plan investments that already are affected by energy prices, he said.

The asset sizes of these pension plans are affected by energy prices because companies are able to make greater contributions to their defined benefit plans when the companies are doing well, Mr. Bragar explained.

“These companies do well when commodity prices are lower,” he added. “It intensifies the need for oil and gas to be an input” in the analysis.

Energy prices also are a big factor in real estate portfolios.

“Real estate — commercial and residential — very quietly has become the biggest consumer of energy, ahead of transportation and manufacturing worldwide,” said Jacques Gordon, global head of research and strategy at real estate money management firm LaSalle Investment Management, Chicago.

In the first two months of this year, residential and commercial real estate owners and occupiers consumed 7,271 quadrillion British thermal units of total U.S. energy compared with 5,913 quadrillion by the electric power sector; 5,083 quadrillion Btu by the industrial sector; and 4,228 quadrillion Btu by the transportation sector, data from the U.S. Energy Information Administration show.

The real estate sector has one of the highest carbon footprints, contributing 30% of global annual greenhouse gas emissions and consuming roughly 40% of the world's energy, according to the UNEP Finance Initiative, a partnership between the United Nations Environment Program and the financial sector.

Real estate landlords have been taking steps in recent years to reduce energy consumption, lowering costs for tenants that pay the energy bills and creating a smaller carbon footprint.

“There is a powerful movement in real estate toward green buildings, sustainability and a new concept, "resilience'” — which is building in systems to contend with natural disasters, Mr. Gordon explained.

Even with the swings in commodity prices, energy never really fell out of favor as an investment, said Mr. Bragar.

“In 2014, energy was a really hot sector. Then when oil and gas prices went down ... it became a very popular contrarian play,” he said.

Shift to renewable energy

A combination of factors, including the emergence of economically viable renewable assets and investors' desire to make investments reflecting their environmental social and governance policies, has resulted in investors turning to renewable energy investments.

Fundraising for conventional energy funds — those investing in oil, natural gas, coal, oil-field services or a combination — declined 41% to April 30 from record levels in all of 2015, according to a recent report by Preqin, a London-based alternatives investment data provider.

Indeed, funds investing in fossil fuels accounted for 46% of the energy capital raised between 2008 and April 30, 2017. Some 33% of the capital raised during that period was for renewable energy funds — those focused on biomass, geothermal, hydroelectric, and solar or wind power, or a combination. The remainder of capital raised was for funds that invest in both fossil fuels and renewable energy, Preqin's report said.

Mixed funds have had the most growth recently, raising $19 billion year-to-date through April 30 and $24 billion in all of 2016, compared to $1.9 billion raised by fossil-fuel funds in the first four months of 2017 and $22.3 billion in 2016. Renewable funds raised $4.8 billion this year through April 30 and $12.6 billion last year, Preqin's report shows.

“We are starting to see more renewable (fund) managers out there,” Willis Towers Watson's Mr. Bragar said. “We tend to think that renewables is an especially interesting space.”

Close to half of the firm's clients' energy equity investments are in renewables, he noted.

The renewable opportunity set is larger outside the U.S. due to more favorable policies by foreign countries, Mr. Bragar said. (On June 1, President Donald Trump announced the U.S. would pull out of the global climate accord.)

What's more, investment is in renewable energy is a medium-to-long term trend to replace the coming denigration of fossil fuels, Mr. Bragar said: “We think there are strong tailwinds for renewables in the medium-to-long term.”

Willis Towers Watson defines medium to long term as in the next five to 25 years.

The uptick in renewable energy investing is not exactly welcome news for managers of conventional oil and gas strategies.

“The real long-term threat to fossil fuels is from increased adoption of renewable energy,” said Steven Oh, global head of credit and fixed income in the Los Angeles office of  PineBridge Investments.

Overall, fundraising for alternative investment energy funds is continuing to capture the majority of investors' investment in natural resources.

Within alternative investments, energy fundraising is coming on hot and heavy with investment across alternative investment sectors. The 10 largest natural resources funds that closed last year were all aimed at investing in energy strategies. Some 69% of natural resources funds closed between 2008 and April 30, 2017, and 84% of aggregate capital raised during the same time period, were for energy-related vehicles.

The renewed interest in energy has a lot to do with the recent relative stability in the price of oil.

Oil price impact

The average price per barrel of oil for the first five months of 2017 was $52.30, compared to $44.63 per barrel in 2016 and $50.89 per barrel in 2015.

“A lot of folks were not investing in energy in 2015 and 2016,” said Rich Aube, co-president based in the New York office of private credit manager Pine Brook Road Partners LLC.

“When oil came down hard and fast from $100 to $26 in 2014, the bid/ask spread goes from pretty wide to infinite,” said Mr. Aube, who heads Pine Brook's energy investments.

There was a drop in investment activity across energy in 2015 and 2016, from upstream oil drillers to service companies. “Everyone was in hunker-down mode, causing a lot of distress in the industry,” Mr. Aube said.

“I think most people in the industry believe we've seen the worst. The last two years ... caused the industry to shrink, which is the self-correcting mechanism.”

The industry needed to shrink to allow supply and demand to get close to equilibrium, Mr. Aube said. Once that happens, it will speed the day when the industry will return to growth. 

This growth will drive increased activity in the oil fields that will flow to the equity markets and the mergers and acquisitions markets, he said.

“The fact that the equity markets are returning is a barometer of how public markets are expecting recovery in oil price and activity levels,” he said. The debt markets are slower to recover, he added.

On the private investment side, the wide difference between the price at which sellers are willing to sell assets and buyers are willing to buy assets is starting to narrow.

“Now that oil has found stability, we see sellers more open to part with non-core assets,” he explained.

However, when oil prices go up, more supply is created as oil and gas companies begin pumping again. This creates a ceiling on how high energy prices can go in the near term, PineBridge's Mr. Oh said. Global oil producers need more than $30 to $40 a barrel to generate an acceptable return on capital, he added.

This article originally appeared in the June 12, 2017 print issue as, "The delicate balance of investing in energy".