By Sam Peters, CFA
An energy crisis that has been brewing for decades
We are currently in crisis because the world has underinvested in energy and now lacks electricity. Energy disorders appeared even before horrible events in Ukraine. However, the conflict sparked a geopolitical crisis that reminded the world that power is one of the most effective strategic weapons. This crisis will stimulate much-needed investment in energy, both traditional and renewable, as energy security merges with an acceleration of the energy transition. The big challenge is that energy security and transition will take time and billions of dollars of investment. We believe that the dominant narrative and driver of the current market cycle will be to meet this great challenge.
How did we get here? In the post-2000 equity bubble, the dominant market narrative was the explosive demand for energy and commodities from emerging markets. The thesis was that the economies of Brazil, Russia, India and China (BRIC) would overtake the six largest Western economies by 2030. The growth of these BRIC economies would drive such a large structural demand for raw materials, especially energy, which supply would never catch up with. Investors were underweight commodities during the latter stages of the BRIC madness. It dominated daily financial news, was at the center of every meeting, and was accepted as truth. How could we not realize that the world was simply lacking in things?
The main concern was that US energy dependence was growing rapidly (Figure 1). The data showed that US oil and gas reserves were rapidly shrinking, US energy insecurity was rapidly increasing, and desperate solutions were emerging. As a result, the United States was gearing up to import liquefied natural gas (LNG), renewable energy investments in solar and wind were increasing, and some crazed energy companies were attempting the impossible: fracking.
Exhibit 1: Energy Dependence and Independence
Fracking was originally a fringe idea that energy experts have largely dismissed. But after a fortunate mistake when a drilling crew mismixed the fracturing fluid, it produced surprisingly good results for natural gas. Then, to everyone’s surprise, it worked with oil. The United States has become the largest oil producer in the world and has taken an incredible and unimaginable path to energy independence. The byproduct, of course, was that energy and most commodities suffered a violent bear cycle that relegated the BRIC narrative to the dustbin of market history.
This shift from a narrative of energy insecurity and scarcity during the BRIC market cycle to energy security and abundance during the FAANG market cycle has been a critical factor. The shale boom and the massive expansion of Chinese production, fueled largely by cheap thermal coal, were in fact massive deflationary catalysts. With nominal growth also held back by private sector deleveraging after the Great Financial Crisis, investors focused on finding secular producers completely insulated from anemic cyclical growth. Moreover, these massive deflationary winds freed monetary policy from inflationary concerns, with the Fed’s “put” becoming essentially costless. This allowed interest rates to fall to their lowest level in 5,000 years and an ocean of central bank liquidity to flood the world.
There is an inescapable cycle around energy: the extrapolation of scarcity and abundance eventually leads to the opposite reality as we under-invest and over-invest. During the last cycle of energy abundance, we once again expected to have excess energy, and concern shifted from energy security to the growing existential crisis of climate change. We had to stop the dirty energy and do it quickly. As a result, energy capital expenditures collapsed and we found ourselves in a familiar position. Supply growth began to decline relative to demand, and this imbalance accelerated as demand returned to record highs as we recovered from the COVID-19 collapse.
This brings us to the present. Even before Ukraine, Europe was facing an energy crisis with soaring prices for natural gas and oil. Most commodity prices, especially key metals for the energy transition, have also risen dramatically as demand outstrips supply. Then the Russian invasion happened and the crisis became a real inflationary calamity.
Energy independence requires accelerated investments
Energy cycles are measured in years, not months. This is especially true with the current cycle, as the response of capital spending to rising prices has so far been extremely subdued. Solving the challenges of energy security and energy transition will require serious innovation as well as experimentation.
However, the market now has a clear call to action to make Europe energy independent, accelerate the energy transition and take the “power out of power” from Putin. These goals will be met, but it will take investment spending on renewable and traditional energy more than doubling rapidly by at least $1.5 trillion a year. These expenses will allow the following major things to happen:
- US LNG exports will increase significantly to help Europe shift away from Russian natural gas over the next few years. LNG technology is well established, the US is effectively the Saudi Arabia of natural gas and Europe is desperate for it to happen. The key will be for US policy to pivot. We think so, but it is a risk factor.
- A global transition to cleaner U.S. natural gas should help make significant progress toward global climate goals. US natural gas has about half the greenhouse gas (GHG) intensity of Russian gas (Figure 2), but beyond its inherently cleaner quality, US natural gas producers are developing processes and new and innovative technologies to help achieve climate change goals. These include the phasing out of pneumatic controllers for more efficient low bleed designs, increased investment in leak detection and repair equipment to significantly reduce emissions releases, and the use of ” green completions” to capture gases released during the fracturing process. For example, the natural gas exploration and production company EQT (EQT) has set 2025 targets of net zero GHG emissions and a 65% reduction in methane emissions from pre-pandemic levels. Additionally, EQT’s initiative to transition its conventional diesel fracturing fleet to electric fleets powered by natural gas turbines has enabled the company to eliminate more than 23 million gallons of diesel fuel from its operations. just in 2020. US LNG producers also actively share industry-wide best practices through organizations such as the Oil and Gas Methane Partnership.
Exhibit 2: Appalachian gas offers a superior alternative
- Additionally, the disruptive innovation of shale gas to replace coal reduced US emissions by 970 million metric tons from 2005 to 2019 (Exhibit 3). The reduction in GHG emissions from switching from coal to gas was greater than all other efforts combined to mitigate GHG emissions. Replicating it globally with U.S. LNG exports is the fastest and most effective way to achieve energy security and transition goals.
Exhibit 3: Switching to shale makes a difference
- Renewable investments must be accelerated significantly. This includes wind, solar, nuclear and hydrogen, renewable energy storage and carbon capture. As the innovation process accelerates, we believe advancements will be made that most experts would consider impossible today.
- Nuclear energy must be reconsidered. We rate the efficiency and power density of different energy systems by a ratio – energy return to energy invested (EROEI) – which measures the amount of usable energy delivered relative to the total energy used in its production. The higher the number the better, and nuclear leads the pack with an estimated EROEI of 75:1 versus 50:1 for hydro, 30:1 for coal, 28:1 for gas natural, 19:1 for solar in sunny areas, 16:1 for wind, 4:1 for solar in cloudy places like Germany, and at best 1:1 for ethanol. In addition, nuclear does not emit GHGs. The only two systems that should be phased out are coal due to GHG emissions and ethanol because burning food is simply not efficient. The key message is that we need a combination of energy systems to keep us stable during the transition. Moving to lower energy densities and efficiencies would put pressure on economic growth while fueling inflation.
Change creates secular opportunities
We are still only at the beginning of a new market cycle driven by massive changes that the Ukrainian crisis will accelerate. Since the start of the invasion, approximately 30% of planned LNG export capacity in the United States has been booked with new orders, resulting in new sources of financing for the 10 LNG export facilities under development along the US Gulf Coast. Moreover, the Biden administration’s commitment to send an additional 15 billion cubic meters of natural gas to help Europe rid itself of Russian imports only reinforces our belief that American natural gas will prove to be a essential bridge as we move from legacy energy sources to emerging energy sources.
One of the biggest challenges in investing is that in every market cycle, investors must ride the great wave of change and opportunity because above-market returns are not normally distributed. FAANG stocks were obviously the big wave of the last market cycle, and we think power and energy – covering a spectrum of LNG, nuclear, solar, wind, storage, carbon capture and hydrogen – will be the big wave. of this one.
Sam Peters, CFA, is Managing Director and Portfolio Manager for ClearBridge Investments’ Value Equity Strategies and All-Cap Value Strategies.
 EQT Corporation. (2020). Empowering Evolution – EQT ESG Report 2020. https://esg.eqt.com/content/EQT_2020_ESG_Report.pdf.
 Sergio Chapa and Sophie Caronello, “US LNG transactions surge with 30% of forecast export capacity sold,” Bloomberg, May 3, 2022.