The Energy Transition From Fossil Fuels Will Power These Stocks -Including Big Oil

The Energy Transition From Fossil Fuels Will Power These Stocks -Including Big Oil

Jul 27, 2024 10:37am

By Jakob Wilhelmus

Natural gas, LNG and pipeline plays are a bridge to renewables from petroleum and coal

Fossil fuels will be with us for many years – though more in the form of natural gas than coal and petroleum.

To limit climate change, the 2016 Paris Agreement aims for net-zero CO2 emissions by 2050, and investors have followed the flood of government money destined for firms and technologies committed to the green transition. However, the trickiest part about investing in the energy transition is accepting that two seemingly contradictory points can both be true at the same time. Yes, renewable energy is the key to meeting future power needs with fewer carbon emissions. But no, fossil fuels will not easily be replaced and will, in fact, have a long sunset.

Every past energy transition has supplemented existing energy sources rather than replaced them. This transition will be no different. Many industrial processes and forms of transportation we rely upon today, such as steel-making or airplanes, currently have no economically viable alternative to fossil fuels.

A balanced and resilient electricity grid requires both renewable power and fossil fuels. This reality is often overlooked, creating investment opportunities in a variety of segments across the energy sector.

Modernizing the grid

For investors who want to take part in the energy transition irrespective of the energy source, the near-universal need for larger and smarter grids present providers of key grid components and construction services with a powerful tailwind. The International Energy Agency estimates that to power itself primarily with renewable energy, the world would need to add or replace nearly 50 million miles of transmission lines by 2040.

This astronomical number highlights the imbalance that exists between buildup of power generation and supporting infrastructure. For investors, that creates opportunity around the complementary infrastructure that is needed to build out the grid. Companies such as Eaton (ETN) that provide essential components – including inverters or substations for transmission lines – are well-positioned to take advantage of these ambitious goals. Their central role in the energy transition over coming years may not be fully appreciated today, but markets might soon catch up.

For investors, it is critical to seek energy-sector companies that are forward-looking.

Shifting to the greener end of fossil fuels

Fossil fuels will certainly continue to be a component of the energy system of the future – albeit a smaller one and probably more in the form of natural gas than coal and petroleum. Indeed, global demand for liquified natural gas (LNG) is expected to grow by more than 50% by 2040 as the coal-to-gas transition expands in China and South Asia. This new energy system promises to divide today’s energy majors into winners and losers.

Some will rely on the extended sunset of fossil fuels and focus their investments solely on continuing to provide fuels of the past – namely, petroleum and other fossil fuels. These firms run the risk of being rendered obsolete by efficiency gains and better infrastructure in renewables. And they may ultimately be defined by the magnitude of their stranded carbon assets that are no longer economically viable.

For investors, it is critical to seek energy-sector companies that are forward-looking and are finding ways to remain energy providers regardless of what the primary energy sources might be. Two such companies are TotalEnergies (TTE) and Shell (SHEL), which are expanding natural-gas production and transport capabilities. These companies are well-positioned for the energy transition, as gas and LNG both make up a significant and growing share of their overall revenues and profits. At the same time, markets seem to not yet appreciate this shift, as these companies have been trading at a discount to their less-diversified peers such as ExxonMobil (XOM).

Pipelines are another way to take advantage of the global shift to natural gas. Often these firms have long-term purchase agreements in place, providing investors with an attractive “toll collection” that provides a differentiated risk-return proposition in the natural-gas space: exposure to booming demand with less exposure to short-term price volatility. These characteristics and accompanying cash flows make major pipeline players including Enbridge (ENB) and Kinder Morgan (KMI) particularly interesting for debt investors.

Getting smart on energy use

Meeting growing demand and building out capacities are a big part of the energy transition. Investors should also pay close attention to innovation around managing demand and using energy supplies more efficiently.

In the past, the electricity system was mostly a one-way street from large, centralized power plants to end-consumers. Today the system is much more dynamic, and both operators and consumers have gained insight into their electricity usage as well as control over when and how to use it.

This has created a two-way system, where customers actively manage their energy consumption through smart appliances or storage, while system operators have increased capabilities to manage electricity distribution and generation. This development might benefit companies, such as Schneider Electric (SBGSY), that

provide smart sensors and devices all the way to the software that allows grid operators to optimize supply and demand.

There is no question that renewables are overwhelmingly the first choice for new power generation – global renewable capacity grew by 50% in 2023 and these sources offer some of the lowest cost of producing electricity today. But even this pace of growth in renewables may not be enough to account for the steep rise in energy demand. Investors who ignore the critical and transitionary role of lower-emitting fossil fuels and associated infrastructure may miss out on the best risk-return opportunities as the world makes the long and complicated transition to a clean-energy future.