Evaluating Investment Opportunities in an Era of Energy Transition
As part of Richter’s webinar series, Navigating Through the Noise, we had the pleasure of interviewing Tyson Birchall, Managing Director of Longbow Capital Inc.; and Jason Landau, Managing Director, Portfolio Manager, and head of the investment team at Waratah Capital Advisors. The following is a summary of this interview – hosted and moderated by our Athas Kouvaras, Client Relationship and Development Manager.
The discussions with our guest speakers focused on how this transitional period in the energy field is approached and reflected within their portfolios. Each guest also provided their insights on why fundamental economics will always play a key role in how the world’s energy needs are met.
This enriching discussion, led by our moderator, Athas Kouvaras, was kicked off with a quick introduction to our guest speakers.
Tyson Birchall, Managing Director, Longbow Capital Inc.
Prior to his position as Managing Director at Longbow Capital, Tyson was the VP Investment Banking at Tristone Capital, a global energy specialist investment bank. Longbow Capital Inc. has been in business for 25 years and manages approximately $900m. Their roots have been in the oil-and-gas sector but, over the last decade, have diversified into energy technology, services, infrastructure as well as those in the business of generating and supplying power. They have recently closed a $181m fund dedicated to investing in energy transition and related businesses.
Jason Landau, Portfolio Manager, Waratah Capital Advisors Ltd.
Jason joins us with extensive knowledge of the North American oil and gas sector, having focused on this sector since the beginning of his career. Currently, he is the Portfolio Manager at Waratah Capital Advisors. The firm manages $3.4 billion across six public equity long-short strategies and three private equity vehicles. The company has experienced steady growth over its 12 years of operation. Jason spends approximately half of his time managing a new ESG long-short fund. Part of his focus has been on using ESG to drive incremental returns by uncovering new longer-term ideas and themes within the market to capitalize on.
Question 1 from Athas Kouvaras:
A growing portion of the investment community believes that Environmental, Social and Governance (ESG) factors are positively correlated with higher risk-adjusted returns (in contrast to Socially Responsible Investing during the ‘90s). Focusing primarily on the “E”, do you believe that portfolios tilted towards positive environmental factors can outperform completely unconstrained portfolio management?
Jason Landau (JL): In short, “Yes, but with a caveat”. There are definite opportunities here and Jason noted that we’ve past the point of questioning whether the transition is coming. But there are questions around the timing. By definition, a ‘transition’ will come with steps. Jason sees a much greater focus on Liquefied Natural Gas (LNG) as well as nuclear energy as we move forward. His firm are realists about this transition – noting that many of the opportunities lay in the subsets of the energy transition.
“The Tesla driver still wants their Amazon packages delivered same-day. Or a student ordering a package from the comfort of home could result in a coal plant for production, rail and trucks to deliver it to a port, sea travel, and then back on to a train or truck.”
Tyson Birchall (TB): Tyson adds, in some cases, the ‘ESG narrative’ will gain traction and the results can become a self-fulfilling prophecy – an ESG-tilted portfolio then starts to outperform which creates capital flow into that sector and further outperformance. However, over the course of the business cycle, a more granular approach is needed.
Ultimately, companies have to sell products that are at a competitive price and perform how customers want. Caution must be taken when a business plan relies on consumers paying a premium or the cost structure is higher than the competitors.
There is opportunity, but the underlying businesses need to be examined. For example, this transition is, and will continue to put, a major strain on our energy grid; the difficult and disastrous results of that have been seen in Texas and California. Our grid is a $10 trillion asset that will be the backbone of a greener economy. A business that has a product or service that reduces exposure to these problems or helps solve them will “have a massive tailwind for a long time.”
Question 2 from Athas:
Some funds have communicated they’ll be eliminating all exposure to fossil fuels. Does the process of negative screening, or the process of avoiding investments or entire sectors – such as oil and gas — that are tied to negative ESG measures, actually work? Or does it simply transfer the holdings of those securities to others at a good price?
TB: The nuances are important here. The best that can be hoped for from a mass-divestment approach would be that it raises the cost of capital for hydro carbon business, resulting in less investment, which lowers supply, causing the prices of a commodity to rise, which would make alternative fuels more competitive. Whether that actually happens is debatable at best. Consumption hasn’t changed, so without a major behavioural change to coincide with a divestment in hydrocarbon production, other markets like Saudi Arabia and Russia will simply fill the gap.
Advocating change from within, as an investor, may yield much better results. As an example: A tiny hedge fund called Engine No. 1 got a seat on Exxon’s board and have been able to have an impact on the business – this was a result of buying shares, not selling.
JL: Divesting has the potential to put assets into the hands of people that don’t care about sustainability. Voting with dollars and proxy is a far better way to invoke change. Investing in businesses that can be part of the change also has merit on many levels.
TB: We’re now seeing executive compensation being tied to lower emissions. On the surface, this is a good thing; but how this gets executed really matters. The easiest means of capitalizing on this incentive is by selling your highest emitting assets. Now an asset that is a problem has been transferred from a well-capitalized company, that generally follows the rules, to someone who has purchased it because it’s cheap. Potentially, that shifts the asset into weaker hands and does nothing to lower carbon emmissions.
Question 3 from Athas
If negative screening is at one end of the spectrum, let’s talk about positive screening – or, actively seeking investments that exhibit positive environmental factors and/or technologies that aim to improve the environment. How do you separate clean-tech hype from practical economic reality as a portfolio manager?
JL: Staying true to the fundamentals of investing is the best way to evaluate every opportunity – including green tech. There has to be a business case and proof of real cash flow now or in the foreseeable future. Currently, Waratah Capital doesn’t have a large portion of their portfolio dedicated to renewables – citing the economics just haven’t made sense – but they are getting more attractive. Their approach is zeroing in on companies that have a solid framework and business model for the future. He notes, there is “an unbelievable opportunity for our Canadian natural gas to displace coal-fired power generation in Asia.” Canada has the highest environmental standards of any oil-and-gas producing nation in the world — this has the potential to make a positive difference.
TB: These are complex problems; thus, there needs to be a realistic timeline for how the solutions unfold. There is amazing innovation happening out there – some of which is having an impact now, others will have an impact in the future, and some never will, which is just the nature of science. He notes that Longbow Capital prefers innovation that looks like adaptation – an approach that can have a real impact today and make a profit. As an example: Longbow Capital has an investment in a micro-grid company that helps decarbonize oil-field operations. This is achieved by providing industrial scale, low-emission, remote power generation technology that creates electricity and displaces diesel consumption. Overnight, their customers can cut their CO2 emissions by 30%. They don’t have to sacrifice anything operational, nor do they have to spend any money. Today, that product is in the market and creating a fabulous return while reducing CO2 at a profit.
“You can suspend the laws of economics for a short time through exuberant capital markets and government subsidies, but you can’t suspend the laws of thermodynamics for even one second.”
Question 4 from Athas:
Given the attention on clean energy, many people are looking to reposition based on this trend. Give us a couple of themes of what you’re looking for on the long side of your portfolio.
JL: Jason notes that battery storage interests his team. Based on current trends, it seems that every household may be running off of a battery – which will pull and store electricity from the grid. As more adverse weather events occur, causing blackouts, battery storage becomes of increasing importance. Also of interest is carbon capture technology. The concept of carbon capture and storage (CCS) can turn an expense into a revenue source. By 2030, Canada’s oil sands will incur roughly $500m in costs in carbon taxes – provided tax levels remain the same. If a CCS facility can be built collectively, and with government support, this could be very lucrative and effectively enhance decarbonization efforts.
TB: Tyson states that Longbow Capital has focused on the “picks n’ shovels” side of the business within supply chain, wind industry, and solar industry. As an example: They’ve invested in a business that helps optimize the performance of windfarms and has launched an insurance product for the wind industry. Insurance, on the surface, may not seem important, but it is a major factor when it comes to getting developments built.
He notes that while they have interest in these supporting businesses, they likely wouldn’t invest directly in wind or solar energy because the returns are too low for what they’re looking to achieve. The power-generation industry is also seen as an enormous opportunity. The electricity grid – a $10 trillion asset – will need to be rebuilt and reinforced.
Question 5 from Athas:
Can you compare the opportunity set and the influence of the public versus the private market? Your fund is in the private market, these are private equity positions, what are the pros and cons of that approach vs the public market?
TB: In general, its recognized that there are great opportunities in the public market, but much of what’s happening there is on a smaller scale. At this stage of the energy transition, it’s believed that the biggest opportunities are in the private market.
What is appealing about this investment theme is that large industries are now behaving differently than they have before. Now, giant industries are thinking about how they’re going to exist in a lower-carbon world. Companies are more willing to invest in vendors who can help solve these problems.
Question 6 from Athas:
Jason, your alternative ESG or ASG strategy not only looks for securities with positive environmental attributes, but also short stocks that might be adversely affected by these factors. How does the process of establishing short position differ from the long book? Is it enough that the shorts have negative ESG characteristics or do you always look for a catalyst in place when you put on a short, or are they pairs for the longs?
JL: Shorting reduces risk in a portfolio. The evaluative process is similar whether going with a long or short stock. For example: Couche-Tard is a global leader in gas stations and convenience stores. Essentially, they sell gasoline, tobacco, and sugar. Given these revenue streams, every year their discounted cash flow shrinks. Even without a specific catalyst, achieving returns of similar levels as they have historically will be a struggle. “It’s a slow melting ice cube”.
Question 7 from Athas:
This question posed to both speakers: We’ve seen the Russion invasion of the Ukraine unfolding in recent weeks. While the invasion has been a recent development, it raises a valid concern about Europe’s lack of energy supply which has been a topic long before the current situation. Kindly share your thoughts on how things may play out with respect to relying less on Russian gas in the future; nuclear has been mentioned though some countries have shut their plants down, will they rethink that? How do these factors fit into the overall energy puzzle? How much can be realistically fulfilled with renewable energy today versus the future?
TB: Energy has played a critical role in international conflicts over the past century. Currently, Russia supplies about 30% of Europe’s energy. This current situation highlights Canada’s inability to achieve stronger Liquefied Natural Gas (LNG) production – which will now become a detriment to Europeans. Optimistically, Tyson doesn’t believe it’s in anyone’s interest, Russia or western countries, for Russia to stop providing their energy to Europe. He believes a drop in supply would make the situation worse. Since Russia is one of the top three energy-producers in the world, even losing half of their production would result in $200/barrel oil prices overnight. He also notes that energy is 65% of Russia’s exports; not being willing or able to supply world markets would be crippling to their economy.
Currently renewables aren’t an effective way to close the gap. Nuclear and LNG have the potential to be winners here in the long run. However, these options would still be unable to fill the void left if Russian supplies go offline.
JL: Germany has plans to create a strategic natural gas reserve. They currently receive 35% of their gas from Russia. Countries around the world are quickly learning that having this kind of single-sourced dependency can be problematic. Agreeing that nuclear and LNG will be long-term winners, he also believes renewables will play a more significant role. Jason feels this situation will speed up the deployment of capital to renewable initiatives.
Question 8 from Athas:
In the final question posed to our two guest speakers, Athas notes that the general consensus is that if climate change is left unchecked it will cost us all. Yet a fundamental problem is the private-sector needs tend to focus on short-term returns while pension plans and governments tend to have longer-term horizons. How can these institutional investors and stakeholders be encouraged to float bonds, or other vehicles that finance the investments to mitigate the cost of climate change — including options like nuclear — which can be a big part of the solution?
JL: There has to be a better education process from media around nuclear. It’s an incredibly safe, carbon-free way of generating energy. Technology in 2022 has the potential to eliminate the human error that has been responsible for the disasters of the past. If the mindset of the general public can be changed, the capital will be available. Jason states that he foresees a world where there is a sustainability bond that Ontario could issue and capital is earmarked for building a new nuclear facility. But there has to be that bridge to better educate.
TB: Short-term profitability can be an issue, buts there has to be real profitability, eventually, in any business that will sustainably contribute to the energy transition. Government subsidies can be helpful, but the underlying economics have to do the majority of the lifting in this effort; no government is big enough to subsidize our way into this. To illustrate this point, he offers that the Canadian Infrastructure Bank has $8 billion earmarked for energy transition. Yet, the estimate to transition our infrastructure is $1 trillion. Since the scale of the challenge is so big, the underlying economics will have to work in order to finance this.
“Part of sustainability is that you have to make money along the way or that business won’t see its way to a green future.”