Analyze This: The Energy Sector

From the quest for net-zero emissions to the war in Ukraine, analyst John Brueggemann discusses the impact of U.S. and world events on the energy sector.

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Matthew Murphy, senior client portfolio manager, recently sat down with John Brueggemann, a senior analyst for Pacific Asset Management, to discuss the latest developments in the global energy sector.

Let's jump right in, John. The energy markets have had an interesting few years. Can you give us a bird's-eye view of what's affecting global energy markets right now?

Certainly. I would characterize what we're seeing today as something that's been years in the making. When you think about the structural under-investment in traditional oil-and-gas production over the last several years—particularly in the OPEC region—that translates to higher prices. Crude oil is nearly $120 a barrel, and natural gas at $9.31. These are prices we haven't seen in many, many years.

At the gas pump, U.S. consumers for many years have been basically subsidized by U.S. shale investors, and basically those companies burned through cash flow at a high rate and flooded the market with supply. According to Deloitte, from 2010 to 2019, U.S. shale firms invested $1.1 trillion in capital expenditures while they generated negative $300 billion in cash flow.

But now the shale companies are no longer growing production and are trying to keep a flat production profile and return the cashflow to shareholders to spark interest in investing in the sector again.

That's why we're seeing higher prices at the pump and why we think prices are going to be higher for longer.

Do you see a disconnect between what you’re reading in the mainstream media about oil prices and your analysis?

It's interesting. Every day there's a new headline about how consumers are being gouged at the pump by Big Oil, but I believe the high prices are really the result of Economics 101: Until there's a supply response to meet the higher prices or demand is reduced, prices may remain higher for longer. There's simply not been a supply response from U.S. shale companies, and OPEC+ has continued to underperform their quotas. In April, OPEC+ was underperforming their quotas by over a million barrels a day. Then, obviously, with the war in Ukraine and Europe trying to wean themselves off Russian oil and gas has placed even more pressure on the market.

Can you tell us more about how the war in Ukraine is affecting the world energy markets right now?

It's having a major impact. Europe, for instance, imports 40% of its natural gas from Russia. Europe is trying to figure out where to source new energy supplies to displace what they’ve traditionally gotten from Russia. It's putting incredible upward pressure on all commodity prices, really. And that's not a transition that can occur overnight. And you're now seeing severe ramifications from the war. Power prices in Europe are five times the normal average; Europe doesn’t have the ability to source the natural gas and coal that they need to power their grid. It's been a real crisis.

Here’s an example of the impacts. This winter in Europe, it was too cost prohibitive to manufacture fertilizer, and then you ended up seeing that translate into empty shelves in the grocery store. Europe was unable to produce the food required to stock the shelves because it was too expensive to manufacture fertilizer.

I believe the commodity crisis has reared its ugly head in all facets of modern-day life. Energy security has become a real threat, and it's to the point where it's a matter of not running out of commodities, not how high the price is.

And it's a dynamic that's going to continue, I think, for some time, until there's a supply response from either OPEC or U.S. shale. And like I said earlier, the U.S.is likely not going to the high growth years that we saw in 2010 to 2015, where domestic oil production doubled. Shareholders seem to be demanding return on their investment plus ESG-related risks may be driving capital flight out of the sector after investors have been burned over and over again, given the history of negative returns in the sector.

I think the commodity shortages that you're seeing globally are only going to intensify because of the invasion by Russia into Ukraine, and we don't see any easing of those pressures over the near-to-intermediate term.

Let's switch gears and talk about coal-fired generation and the alternative use of natural-gas generation, among other resources, with the goal of lowering emissions. What are you seeing?

Globally speaking, when you think about the emission-reduction opportunity by converting coal-fired generation to natural-gas power generation, the Co2 emissions saved is basically the equivalent of electrifying every U.S. passenger vehicle, powering every home in America with rooftop solar and backup battery packs, and adding 54,000 industrial-sized windmills, which would double the U.S. wind capacity. The decarbonization opportunity presented by converting coal and natural gas represents, I think, the biggest opportunity we have to meet the emissions targets that have been discussed.

There's a lot of discussion about whether these targets, and whether net zero—which means having greenhouse gas emissions close to zero—is even attainable. A lot of experts would argue that the targets have been unrealistic solar and wind-adoption scenarios, especially as the International Energy Agency has propositioned this past winter. You’ve already seen how unreliable the grids were this past winter when they didn't have enough hydrocarbon baseload power generation. The outages have never been greater than we're seeing. That's domestically. That's in Europe. We have to ask ourselves, “Are these targets really attainable?”

So how possible is it that we can completely eliminate coal and oil as sources of energy?

I don't really think that's feasible. Again, we can convert many of the world's coal plants to natural gas, but renewable sources are not reliable sources of baseload power. Also, when you think about replacing fossil fuels, you have to replace them with metals.

Let's just isolate lithium, for instance. Lithium being the metal that makes the batteries for electric vehicles. A lot of forecasters estimate that we would have to build 20 of the world's biggest lithium mines just to meet the 2030 aspirational carbon-reduction targets in the Paris Accord. And it takes basically 15 years for a new mine to come online. And that’s just the scenario for lithium.

I’m not sure people appreciate how much oil and gas is used daily aside from powering cars or heating homes.

That's an interesting point. I don't think that necessarily gets a lot of press—just how big a part of everyday life oil and gas plays. Cell phones, food packaging, hard plastics, computer parts—all this is able to be manufactured because of crude oil.

Given our discussion today, where do you see the opportunities in the energy sector?

I think the most interesting opportunities we are currently seeing in the markets may be available in natural gas-based exploration production companies. We think that natural gas prices are going to be higher for longer given it's viewed as a bridge transition fuel like we've been talking about. We believe all the related infrastructure such as the midstream pipelines that goes into moving those molecules may be some of the most attractive opportunities.

Earlier we were talking about Europe trying to wean themselves off Russian natural gas, So, where are they going to source that gas from? U.S liquefied national gas capacity is looking to double in the next five years as the U.S. looks to help support Europe.

Any performance data quoted represent past performance, which does not guarantee future results.

The views in this commentary are as of the publication date and are presented for informational purposes only. These views should not be construed as investment advice, an endorsement of any security, mutual fund, sector or index, or to predict performance of any investment. Any forward-looking statements are not guaranteed. All material is compiled from sources believed to be reliable, but accuracy cannot be guaranteed. The opinions expressed herein are subject to change without notice as market and other conditions warrant. All third-party trademarks referenced belong to their respective owners.

All investing involves risk, including loss of principal.

Investors should consider a fund’s investment goal, risks, charges, and expenses carefully before investing. The prospectus and/or summary prospectus contains this and other information and should be read carefully before investing. The prospectus can be obtained by visiting PacificFunds.com.

Pacific Funds are distributed by Pacific Select Distributors, LLC (member FINRA & SIPC),a subsidiary of Pacific Life Insurance Company (Newport Beach, CA), and are available through licensed third parties. Pacific Funds refers to Pacific Funds Series Trust.

Pacific Life Insurance Company is the administrator for Pacific Funds. It is not a fiduciary and therefore does not give advice or make recommendations regarding insurance or investment products.

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