Smiley Acess Group

Weathering the storm: what climate change means for investors’ portfolios

Climate change is affecting corporate policy the world over. As a result, it is also influencing the types of assets investors are including in their portfoliosThis past November, more than 11,000 scientists from 153 countries signed a statement in which they warned that “climate change has arrived and is accelerating faster than many scientists expected”. The evidence presented is clear and irrefutable, leading some governments and corporations to take action. But what does climate change have to do with the portfolios managed by South America’s pension funds?The profitability of a portfolio is related to the value of its underlying assets, which can be directly affected by climate change. The impact is likely to be a negative one, stemming from physical risks that arise from an increase in extreme weather events, such as the devastating forest fires that Australia has been suffering from since September 2019. The bushfires have claimed human and animal lives, and caused immense damage to infrastructure and biodiversity.For businesses, climate change can involve a loss of assets, a reduction in sales due to the impact on their supply and distribution chain, and higher insurance costs. These factors have a notable influence on the financial health of the underlying assets contained within portfolios. For example, Californian gas and electric company PG&E filed for bankruptcy in January 2019 following the deadly fires that hit the state the year before. Experts point to this as the first bankruptcy related to climate change; it is unlikely to be the last.The profitability of a portfolio is related to the value of its underlying assets, which can be affected by climate changeTime to act
The need to transition to a low-carbon economy is widely accepted today, and several corporate agreements have been made with the objective of meeting the targets of the Paris Agreement – namely, to stop the global average temperature from rising two degrees Celsius above pre-industrial levels. In its October 2019 Fiscal Monitor, the International Monetary Fund stated: “Policymakers need to act urgently to mitigate climate change and thus reduce its damaging and deadly effects.”It is expected that the implementation of green policies will accelerate between 2023 and 2025. Portfolios should prepare for this change. New regulations could bring about a number of transition risks, including increased costs for corporations in terms of carbon taxation, which can substantially change the risk profile of a bond issuer or the value of a share. Loss of value in assets might also occur; lucrative oil reserves, for example, could be left unexploited as companies strive to meet the two degrees Celsius objective. Demand-side risk should also be considered as more consumers seek products and services from companies with a low environmental impact. Reputational risk might also occur, which may affect a business’ ability to attract talent or implement structural changes in its customer base.Fortunately, climate change does not only present risks for portfolios; opportunities are also created. In 2018, the International Energy Agency reported that 28 percent of electricity generation came from renewable sources. This is predicted to reach 49 percent by 2050 (see Fig 1), providing investment opportunities in different instruments, including green bonds. Likewise, companies that are better prepared for these transition risks may not only be more competitive in terms of energy efficiency, but will also benefit from greater demand and access to capital flows.It is crucial that investors mitigate physical and transition risks in portfolios and are able to capture any opportunities that emerge. At Prima AFP, we recognise the importance of knowing if the companies in which we invest are clear about these risks and if they are prepared to manage them properly. Lasting change
Today, it is increasingly evident that sustainability will be on the agenda of corporations, investors and regulators for the foreseeable future. In a survey conducted by Bain & Company, 81 percent of firms said sustainability is more important in today’s corporate agenda than it was five years ago, and 85 percent believe it will be even more so in five years’ time.It is more vital than ever that companies consider environmental, social and corporate governance (ESG) factors in their management and that they seek to generate competitive advantages as part of an integrated sustainability strategy. According to Goldman Sachs’ analysis of companies on the S&P 500 Index, since 2010 there has been a 75 percent increase in the number of organisations that presented sustainability issues in their quarterly results. In 2018, 85 percent of the companies that were part of the S&P 500 published sustainability reports.The asset management sector is not immune to this shift. More institutional investors are integrating sustainability issues into their investment processes. The number of signatories of the Principles for Responsible Investment has now reached 2,300, with a collective wealth of a little over $80trn in assets under management.The 2018 sustainable investment review from the Global Sustainable Investment Alliance (GSIA) found that sustainable investing assets in Europe, the US, Japan, Canada, Australia and New Zealand were worth $30.7trn at the beginning of 2018, a 34 percent increase since 2016. Sustainable investments already represent 26 percent of the total assets managed in the US, still far from the 49 percent recorded in Europe. The definition of sustainable investing varies between organisations, but the GSIA’s interpretation is generally accepted as the global standard. It consists of seven criteria that determine whether an investment can be termed sustainable. These include negative or exclusionary screening (which excludes certain sectors, companies or practices from a fund due to a failure to meet ESG criteria) and positive shareholder action, where investors influence corporate behaviour in an environmental manner.The reasons behind the growing interest in sustainability are many. According to a survey published by BNP Paribas, the main motivations for ESG investing are improving long-term returns (cited by 52 percent of respondents), followed by management of brand reputation (47 percent) and decreasing risk (37 percent).A higher purpose
A number of studies have examined the factors influencing a company’s approach to sustainability issues. A meta-analysis by Oxford University and Arabesque Partners found a correlation between sustainable business practices and economic performance. Across 200 sources, 88 percent of those with robust sustainability practices showed better operational performance, leading to higher revenues. In addition, 80 percent of sources showed that sustainability practices have a positive impact on financial performance.Regarding the reduction of risk, the World Economic Forum’s Global Risks Report 2019 found that five of the 10 most likely risks were related to environmental issues. Only two concerned technology, two were societal and one was economic.Weather manipulation tools, for example, could increase geopolitical tensions even as they offer a way for nations to mitigate some of the risks associated with climate change. A growing disconnect between urban and rural areas, food supply disruption, water shortages and issues related to space debris were all highlighted by the report as causes for concern.This makes the incorporation of sustainability factors into investment decisions more relevant than ever. Rating agencies are already including these factors in their metrics. Between July 2015 and August 2017, Standard & Poor’s had 106 cases in which environmental risks prompted changes in ratings. Similarly, last year, Moody’s highlighted 11 industries that were at risk of being downgraded due to concerns about carbon generation. As climate change policies are set to reshape the global economy, it is understandable that credit rating agencies are responding accordingly.I want to leave you with a comment that Larry Fink, founder of BlackRock, the largest asset manager in the world, made in his annual letter to company CEOs in 2019: “Purpose is not the sole pursuit of profits, but the animating force for achieving them. Profits are in no way inconsistent with purpose – in fact, profits and purpose are inextricably linked.”

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Central banks around the world react to COVID-19 outbreak
Several governments, including the US, Italy and Iceland, have imposed emergency fiscal measures to limit the impact of the coronavirus
Bank of England Governor Mark Carney arrives at a news conference to announce the bank's decision to cut interest rates to 0.25 percent in response to the coronavirus outbreak
Politicians and central bank governors have reacted en masse in an effort to prop up their economies in the face of the coronavirus. On March 11, Iceland became the latest state to take such contingency measures, after the country’s central bank cut interest rates by 50 basis points to 2.25 percent.

Mirroring the move, the Bank of England announced an emergency rate cut from 0.75 percent to 0.25 percent on the same day, just over a week after the US Federal Reserve revealed similar measures of its own. However, while the cuts have proved effective in bolstering stock markets, they will struggle to solve many of the other challenges associated with the virus’ spread, including supply chain disruption and sharp falls in consumer spending.

“The European Central Bank is due to report tomorrow and we’re expecting a reduced rate also, but it’s a mistake for central banks to use the coronavirus as an excuse to lower interest rates,” Celine Hartmanshenn, Global Head of Risk at Stenn International, said in a statement.

“It would be more effective for governments to introduce temporary tax breaks, new loan programmes, or other financing to companies hurt by the virus. This is all about raising stock prices and lowering borrowing costs. The measures put forward by the world’s bankers can’t keep workers from getting sick or factories from closing.”

Around the world, however, some governments have imposed additional economic measures to mitigate the impact of COVID-19. In Italy, for example, mortgage payments have been suspended and Prime Minister Giuseppe Conte has committed to a €10bn ($11.3bn) fiscal stimulus package.

As well as potentially causing recessions in any number of affected markets, the coronavirus could ultimately cost the global economy as much as $2.7trn, according to some estimates. Governments are swiftly moving on from policies of containment to ones of mitigation. Measures to assuage damage to public health will, of course, be important, but increasingly finance ministers are scratching their heads as they attempt to limit the disease’s economic impact as well.

W&T Offshore: investment in technology crucial to driving returns in the Gulf of Mexico
The Gulf of Mexico accounts for around one sixth of the US’ total petroleum production. Its vast resources are best utilised by companies that have extensive knowledge of the region
Having operated there for more than 35 years, W&T Offshore believes the Gulf of Mexico is the premier basin in the US for generating strong, sustainable cash flows
W&T Offshore has been active in the Gulf of Mexico (GOM) for more than 35 years, and knows the basin extremely well as a result of our keen focus in the region. We have always prioritised free cash flow generation and believe the GOM is the premier basin in the US for generating strong, sustainable cash flows. While other energy companies have moved onshore, we have repeatedly increased our position in the region through a series of successful acquisitions and drilling projects.

We have operations in both shallow and deepwater regions in the GOM and intend to remain active in both sectors. We will achieve this through a combination of acquisitions, lease sale participation, and exploration and development drilling on properties we already own or can access via farm-ins. In terms of exploratory drilling, we tend to be more focused on prospects near existing infrastructure so we can put successful wells online quickly. We prioritise projects based on economic returns and cash flow generation, regardless of whether they are in shallow or deepwater regions.

W&T Offshore prioritises projects based on economic returns and cash flow generation, regardless of whether they are in shallow or deepwater regions

Being focused on the GOM for so long makes a big difference. Over this period, we have developed a strong reputation with other operators in the GOM as well as with property sellers. We also work well with all the relevant federal and state regulatory agencies. We are proud of our safety record and have a very strong drilling success record. We believe our positive operational track record, combined with an ongoing successful acquisition strategy, has enabled us to thrive and create value for our shareholders. It’s a reputation that we intend to maintain and bolster over many more years working in the region.

Having a field day
Over nearly four decades operating in the GOM, we have enjoyed a number of successes. In the shallow water sector, a great example is our Mahogany field. Since acquiring the field in 2011, we have substantially expanded its size and depth by drilling or sidetracking 13 new production locations. The field is one of our key assets, and we have a quality inventory of future drilling projects that will enable us to extend the reservoir even further. We have increased production more than 10 times since acquiring the field.

In the deepwater region, a good example is the Gladden Deep well, which we discovered in June 2019. The well was drilled in approximately 3,000ft of water that encountered 201ft of net oil pay. W&T operates the well and owns a 17.25 percent stake in the discovery. The well was completed and placed on production ahead of schedule in Q3 2019, and is currently producing approximately 4,600 gross barrels of oil equivalent per day, with 89 percent of production being oil. We are proud of how quickly and efficiently we were able to get the well drilled and online despite it being a deepwater site, which used to take much longer to drill and start producing.

As well as these successes, we have been granted additional offshore leases, which we have high hopes for. We have been active in federal lease sales for a number of years and participated in two that were held earlier in 2019. We were awarded 15 leases in the first sale in March, when we acquired seven leases in shallow water and eight in deepwater. In August, both leases we acquired were in shallow water. We paid less than $4m for all 17 blocks, covering 83,800 acres. We intend to continue participating in future lease sales, as this is a low-cost way to add new drilling opportunities that complement our existing operations in nearby fields.

Investing in information
We have a pretty simple strategy for acquisitions. We look for properties that meet three criteria: first, they must have positive cash flow and a good reserve base; second, they should have opportunities where drilling can add value; and third, they must allow us to make an impact regarding workovers, recompletions and facility upgrades that can increase near-term cash flow.

ExxonMobil’s Mobile Bay assets met all these criteria, and our purchase of them made us the largest operator in the area. We also understand the Mobile Bay assets very well as we own and operate the Fairway field, which is adjacent to the acquired assets. At the Fairway field, we have more than tripled proven reserves since we acquired it in 2011 by substantially reducing operating costs and enhancing production, without drilling a single well. We believe similar low-risk, high-upside opportunities exist in the Mobile Bay assets.

Currently, one of our priorities is maximising the potential of these new properties. We are looking at how we can improve efficiency and reduce operating costs. W&T Offshore also has an onshore gas plant that is near the one ExxonMobil owned, so we are looking at how to make use of that increased capacity. We have identified several exciting drilling opportunities on those assets and will be seeking drilling permits to potentially begin drilling them in late 2020.

Making the most of our current and future assets also involves exploring any new technological developments that emerge. We are committed to using technology in all facets of our operations, particularly in selecting our prospects and ongoing drilling activities. We have invested heavily in seismic predictors and have developed the expertise in house to fully utilise that technology. Our use of 3D seismic data has significantly reduced our drilling risk and increased our drilling success rate to about 94 percent on all wells since 2011.

Unlike onshore shale plays, where acquiring data over large plays from numerous sources can be beneficial, every offshore field and reservoir is different. Data gathered over a large area in the GOM is not nearly as expensive as it is over a shale play onshore. The processing of 3D seismic data is a major key to our success and we will continue to invest in technology and a team that can best use that technology.

Different from the rest
In recent years, the development of the onshore US shale market has dramatically restructured the global oil and gas market. At W&T, our ability to consistently generate free cash flow helps us differentiate ourselves from competitors. All of the wells we drill in the GOM are conventional wells, compared with unconventional wells in the shale plays. Unconventional wells decline at a much steeper rate, and shale plays require considerably more capital to maintain or grow.

Offshore, we can adjust our capital investments when oil prices fall, while the high porosity and permeability of offshore reservoirs often requires fewer wells to produce large reserves of oil and gas. We have been cash-flow-positive for most of the time, and our strategy is focused on staying that way. We have the luxury of deciding whether to invest our free cash flow in acquisitions, drilling, reducing debt or paying dividends to shareholders. Most onshore exploration and production firms in the shale plays have to keep reinvesting in drilling wells and are trying to become free-cash-flow-positive.

The huge growth in the shale plays has certainly had an impact on the amount of oil and gas the US produces. As an industry, we are exporting more oil and developing liquefied natural gas infrastructure along the Gulf Coast so we can export natural gas as well. For onshore players, this has caused pricing issues when there isn’t sufficient pipeline capacity to move onshore oil and gas production to the right locations. At W&T, we are well positioned to achieve favourable pricing as our crude is needed at Gulf Coast refineries, while our natural gas benefits from good Henry Hub pricing because of our access to a number of pipelines along the Gulf Coast.

As well as competing against onshore shale players, W&T also makes sure to differentiate itself from its offshore peers. To do so, we are primarily focused on acquisitions and staying within the GOM. We believe this approach has served us well in the past, as it has minimised our risk and allowed us to use our expertise to reduce costs, increase cash flow and find additional reserves that were left behind by sellers who have moved onshore and sold their properties to us. We will drill exploratory wells, but our primary focus is on building value through acquisitions. We think our track record in that regard speaks for itself.