27 January 2020
Increased vehicle fuel efficiency and the impact of electric vehicles have led to forecasts that global oil demand may peak perhaps as soon as 2030. Photo: Reuters
Increased vehicle fuel efficiency and the impact of electric vehicles have led to forecasts that global oil demand may peak perhaps as soon as 2030. Photo: Reuters

Energy transition and its impact on credit markets

The energy transition is having a profound effect on global energy markets as renewable energy and global efforts to move away from a reliance on fossil fuels affect both energy demand and supply. This long-term secular shift is gathering pace driven by the disruptive forces of new technology, concerted policy action and environmental concerns.

Globally, the cost of renewable power generation continues to fall precipitously to the point where wind and solar can be the most cost-effective options available. Coupled with high levels of regulatory support towards renewable projects, which often benefit from government subsidies and guaranteed offtake agreements, this economic shift increases the risk that fossil fuel assets (both proven reserves and installed generation capacity) could become stranded in the coming years if renewable energy supply grows faster than previously expected.

Positioning for risks and opportunities

In the power sector, the structural decline of coal versus growth in renewables is a key theme in our credit selection. We have a very negative view on thermal coal, even in emerging markets where it currently remains dominant, as we observe that the same structural issues are present albeit on a more distant timescale. In contrast, we see significant investment opportunities in emerging markets such as India, Argentina and Eastern Europe which are rolling out renewable energy programs.

These views also shape our positioning in the mining sector, where we avoid products in structural decline, such as thermal coal, in order to minimize stranded asset risk. Growing investor aversion to thermal coal in particular is evident in the US high yield market where investor aversion on ESG grounds has significantly increased the risk that coal miners will be unable to refinance their bonds, even at the attractive valuations on offer.

In global oil markets, where road transportation represents approximately half of global consumption, increased vehicle fuel efficiency and the impact of electric vehicles have led to forecasts that global oil demand may peak earlier than previously expected, perhaps as soon as 2030.

This macro view influences our credit selection approach in the oil and gas exploration and production sector, to which our exposure in our global unconstrained bond strategy is currently less than 3 percent of the portfolio. We currently prefer short duration instruments and have invested in bonds with maturities of less than five years which in our view reduces our exposure to energy transition risk. We select issuers with cost-advantaged operations, either through low-cost production assets or labor costs, which are likely to be more resilient in a rapid energy transition scenario.

Management quality is a crucial differentiator in the high yield space. We routinely engage with management teams both before and once invested to understand their approach to capital management. We look for companies with robust commodity price hedging programs to reduce downside risk and management teams who favor capital preservation and balance sheet deleveraging over shareholder distributions.

Management quality is especially important in an environment where the US shale boom of recent years appears to be slowing and credit quality deteriorating. In recent years, many US shale operators have lacked a disciplined approach to capital management, pursuing share buybacks even while their operations have been persistently free cash flow negative. This is changing as bondholders demand a focus on cash preservation and deleveraging.

Energy transition themes and the possibility of tougher regulatory measures also feed into our views on industrials, where we are cautious on companies with highly energy intensive business models and are very underweight ‘traditional’ industrials such as generic steel producers. We incorporate the impact of higher input prices into our models and consider risks around carbon credit costs. This is an evolving area of our research and we are currently considering potential investment ideas among industrials with more resilient business models, such as companies with upstream integration into clean power generation.

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Head of Strategy, Fixed Income at Jupiter Asset Management