War and sanctions ramp up oil prospects

Conventional oil and gas investments might make somewhat of a temporary comeback because of the war in Ukraine and the resulting economic actions that have sent worldwide energy prices skyrocketing, giving alternative managers expectations that they can boost both their exits and returns.

The war is expected to increase demand for oil and gas as countries around the world — most notably in Europe — look to shed their dependence on Russian energy exports with increasing imports from other countries. Russia accounts for roughly 12% of the world's oil and 17% of its gas supplies, according to Schroders PLC.

"With the war breaking out, the question is how will Europe view energy stability when a significant portion of the energy is from Russia," said Gerald Chew, Houston-based managing principal and private markets consultants at Meketa Investment Group. "Going forward, they are going to reduce their reliance on Russian oil and natural gas. The U.S. is poised to increase exports of oil and natural gas to Europe."

That shift to U.S. exports could lead to investment opportunities such as infrastructure for liquefied natural gas to enable export of abundant LNG resources to Europe and elsewhere in the world, he said.

Since 2015, investors have turned away from oil and gas investments in favor of renewable energy and other investments as part of a transition from fossil fuels.

For example, 11 oil and gas funds worldwide raised a combined $4.6 billion in 2021, down from 59 funds that closed on a total of $46.6 billion in 2015, according to Preqin, a London-based alternative investment research firm. During the same time period, renewable energy funds blossomed with 75 funds globally raising a total of $72.7 billion, up, from 66 funds with a combined $30.7 billion in 2015.

Along with rising fuel costs helping to renew interest in oil and gas investments, managers expect more investors to flock to real assets and energy sectors for their inflation-hedging properties as the war propels inflation even higher, and to private equity, which they say often shines in a crisis.

Even before Russia invaded Ukraine on Feb. 24, investors were starting to show some interest in oil and gas investments after years of shunning the sector due to poor returns and asset owners' ESG policies, said Jeffrey J. Eaton, Houston-based managing director and global co-head of placement agent Eaton Partners.

Before the fourth quarter of 2021, fundraising for oil and gas strategies had been "non-existent" due to asset owners' increased emphasis on ESG in their investment policies as well as low returns in the sector going back to 2014, Mr. Eaton said.

In addition to ever-higher energy prices, "people are realizing that shifting to 100% clean energy is a great goal and it is probably going to happen, but it won't happen overnight," Mr. Eaton said.

"A number of big state pension funds reached out to us asking about oil and gas (investments). That was a question we literally did not hear for three or four years," he said.

Because of the war in Ukraine, some investors now think that "we may need to be producing more (oil and gas) in the U.S. ... maybe it is better to produce oil and gas in friendly countries with stricter regulations," Mr. Eaton said. For example, he said, some oil and gas companies are starting to clean the water they use for hydraulic fracturing, or fracking, and also focusing more on methane and sulfur recapture.

Indeed, some asset owners are reconsidering whether to include natural gas in their energy transition strategies because it's cleaner to produce now, Mr. Eaton said. In the past, investors would not invest in energy transition funds that included natural gas, he said.

But while interest in traditional energy is rebounding, Mr. Eaton said, "I don't think we are going back to an energy fundraising market we had eight years ago." Many investors, especially endowments, foundations and European asset owners, are not going back to investing in fossil fuels and the momentum toward energy transition investments will remain strong, Mr. Eaton said.

"But it will be better fundraising for oil and gas than I have seen in a long time," he said.

The earlier fall in popularity of oil and gas investment strategies coincided with dropping Brent crude oil prices, the leading global price benchmark for Atlantic sourced crude. Petroleum prices peaked at $107.95 a barrel on June 20, 2014. By 2020, Brent crude was $47.69 a barrel, according to the U.S. Energy Information Administration. Returns for conventional energy alternative investments also fell. For instance, so far this year, valuations of U.S. venture capital oil and gas investments were equal to capital invested, down from two times capital at the end of the fourth quarter 2021, according to PitchBook Data LLC, a Seattle-based alternative investment research firm.

Brent crude is expected to reach $105.22 per barrel by the end of 2022, according to the EIA.

Rising oil and gas prices are bound to result in an increase in mergers and acquisitions in the oil and gas sectors, leading to more exits and capital returned to investors, Mr. Eaton said.

Also leading to manager expectations on conventional energy is that private markets tend to follow public markets, and energy stocks generally have outperformed the broader markets over the last 12 months, Mr. Eaton said. In February, energy stocks were the market leaders in large-cap and small-cap equities and the only sector that did not suffer a loss, according to a report by S&P Dow Jones Indices LLC.

Public stock investors should expect a lot of volatility from oil and gas stocks as sanctions against Russia by the West and other factors could impact prices, said Dimitry Dayen, New York-based director and senior research analyst for renewables and environmental services at active global equity manager ClearBridge Investments.

Investors should take care when investing in the conventional energy sector, Mr. Dayen said. "To blindly chase energy equities right now probably isn't prudent," he said. "Investors should prepare for significant volatility within this group in the next couple of months."

ClearBridge executives favor investing in oil and gas companies that value ESG and health and safety measures, Mr. Dayen said. Investment in oil and gas companies that pursue strategies to reduce their carbon footprints such as carbon capture, diesel biofuel production and methane emissions reductions are more likely to thrive through the energy transition.

The current spotlight on the European Union's dependence on Russian oil and gas is likely to accelerate the EU's move toward renewable energy, while also sending countries searching for alternative sources of oil and gas, Mr. Dayen said.

"Diversity of supply drives energy security in the European Union," he said.

Countries in the region will start building more terminals to increase import of LNG from places such as the U.S., the Middle East and Australia, Mr. Dayan said.

The combination of higher prices and shifting oil and gas sources could also accelerate the move toward low-carbon economies, money managers said.

"Higher oil prices are a clear negative for all economies and consumers. There is no silver lining unless you are an energy company," said Matt Peron, Denver-based director of research at Janus Henderson Investors. For the world's economies, rising oil prices are "a clear negative and there's really no easy way out other than demand destruction" caused by a transition to low-carbon sources of energy, Mr. Peron said.

Right now, from an equity perspective, higher prices are leading Janus Henderson executives to favor the energy sector, particularly oil and gas. These companies are going to generate a lot of free cash flows with rising oil and gas prices meaning "pure profit for them," Mr. Peron said.

"The only thing that could stop the oil train is demand destruction" with a switch to wind, solar, nuclear and natural gas, he said. This makes renewable energy investments "more interesting now," Mr. Peron said.

"It (clean energy) already had been interesting," he said.

The switch to wind, solar, nuclear and natural gas could quell demand for oil and gas as new technologies develop, such as batteries that make it possible for renewable energy sources to power the grid, Mr. Peron said.

Another factor pushing investors toward energy investments in both fossil fuel and renewable energy is rising inflation, said Meketa's Mr. Chew.

"Over the past year and a half, we've seen an uptick in inflation and it has been benefiting clients' portfolios in commodities, oil and gas, materials and mining, and agriculture such as corn, soybean and wheat," Mr. Chew said. This is a change from the prior 10 years when "we've been in a low-inflation environment, presenting a challenging environment for real assets," Mr. Chew said.

The war in Ukraine is also affecting other real asset sectors, he said. Along with oil and gas, Russia is a major supplier of metals and mining, and food production — and a lot of had been destined for Europe.

This makes farmland "a stabilizer within asset owners' portfolios in a period of high volatility in oil and gas, and on the mining side," Mr. Chew said.

"The value of farmland has been relatively stable because farmland generates revenues from farming opportunities or from collecting rent from farmer tenants," he said.