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Welcome to Episode 57 of Special Situation Investing.
Companies divesting assets for social rather than economic reasons could spell opportunity for savvy investors. We’ve covered oil and gas investments extensively on the show and risk beating a dead horse by addressing the sector again but whenever business leaders resolve to act based on ideology rather than sound economics, opportunity can’t be too far away.
TotalEnergies (TTE) is the company we’ll cover today and we hope to illustrate the broader driving force behind oil and gas mispricing using the specifics of TTE’s recently announced spin-off. To begin, in September of this year, TTE announced its intention to spin-off its Canadian oil sands unit stating that “the assets do not fit with the French oil majors low-emissions strategy.” The final decision is pending a shareholder vote in May of 2023 but it will likely be approved as it is in line with other recently announced decisions the company has followed through with.
What TTE didn’t announce about the divestiture is, in our opinion, more significant than what it did say. Typically, spin-off announcements hit on one or more common themes such as better alignment between management and shareholders, or increased clarity and ease of valuation for the market, or clarification of the capital structure along with a few other classic spin-off reasons. In the case of TTE’s announcement, however, the reason has very little to do with business and a great deal to do with what the company believes to be ethical practices, or put more plainly, climate change.
Divesting carbon intensive assets to serve an environmental policy might be a laudable morale position, but that doesn’t mean its a rational economic one. Consider for a moment the various sources of global energy in 2021. According to Our World in Data, global energy use broke down by percentage into the following categories:
Coal: 27.6%
Oil: 31.6%
Gas: 25%
Nuclear: 4.4%
Hydropower: 7%
Wind: 2.6%
Solar: 1.4%
Other Renewables: 0.5%
To put this in perspective, fully 84% of global energy production in 2021 was sourced from coal, oil, and gas. Green energy proponents often tout the declining oil and gas sector as a percentage of the global energy portfolio, but that obscures the fact that fossil fuel consumption is still growing every year. Yes, more renewables are coming on line, and they represent a growing percentage of the global energy mix, but the total amount of coal, oil, and gas consumed is still trending upward.
Reversing fossil fuel production growth and switching global energy use to a majority renewable infrastructure will take more than just additional renewable capacity. This is because fossil fuels are uniquely transportable and renewables are not. Oil produced half way around the world can and does power industry and transportation on the other side of the planet, while wind, solar, hydro, and nuclear can never fill that void in the same way.
A renewable world must transition energy use from the far flung corners of the globe to a much more localized pattern of generation and consumption. Physical limits to electrical power transmission will require renewable power generation that is much closer to where it’s consumed and that is well suited to the geography and weather patterns of the local area. Whole industries and even population centers that thrived in a fossil fuel world may not be practical in a renewable energy world. This is not to say that the shift is impossible but rather meant to highlight the fact that energy production and consumption are grounded in physical reality and can’t be shifted using climate pledges and corporate mission statements alone.
In preparing this write up, we searched the last several years for examples of fossil fuel divestitures or spin-offs that took place purely for ideological and not financial or business reasons, but couldn’t find any. A few of the oil majors sold assets outright but the sales did not result in a new public company who’s track record could be analyzed post transaction. Given the ever-increasing pressure on oil and gas companies to exit the industry, however, we believe that this trend to divest carbon intensive assets will only increase in the coming years.
With no specific ideological spin-off examples to go on what can we compare the current situation to? At what other time in history did an entire industry become a social pariah without regard to its underlying economics? One example that comes to mind, and its one that’s been widely written about, is the mantra that “oil is the new tobacco.”
Beginning in the 1970s, tobacco went from legitimate social institution to public enemy number one. Tobacco companies could not advertise on TV, were forced to include health warning labels on their products, and were the target of public and private anti-tobacco media campaigns. Despite these headwinds it’s worth noting that tobacco companies have remained quite profitable all the way to the present day.
Despite any obvious similarities drawn from the “oil is the new tobacco” sentiment there is one major factor that the comparison doesn’t account for and that’s the fact that nobody needs tobacco. I’m sure if you’re addicted to tobacco you’d argue against that point, but when it comes down to it the world would not grind to a halt if the tobacco industry were eliminated tomorrow. But remove oil and gas and the world would grind to a halt. If you flipped the switch and shut down fossil fuel production today, society would regress by centuries and experience massive social upheaval along the way.
For this reason, we believe that fossil fuel companies must be allowed to operate until the global energy transition is complete and we believe that day is much further in the future than most people think it is. Individual companies may divest “dirty” assets to improve their ESG ranking, but the industry itself cannot be divested until it is replaced by a new energy system. One that can takeover the eighty plus percent of global energy demand currently satisfied by fossil fuels.
Switching back to TotalEnergies planned divestment of its oil sands unit, leaves us with few specifics about the spin-off due to the fact that the spin-off is not yet approved and we haven't yet seen the financials. Until we see pro-forma accounting statements and review the proposed spin-off’s debt load and capital structure we won’t be able to perform any fundamental or comparative analysis and we won’t be able to complete our assessment of this spin-off’s investment merits. What we can know, however, is that oil and gas are not going away in the next few years.
Additionally, we know that the Canadian oil sands are the third largest proven oil reserve on the planet behind Saudi Arabia and Venezuela. We also know that Canada is an export economy and the majority of its export revenue comes from the fuel industry which ensures a political interest in maintaining oil sand derived jobs, revenue, and taxes. Furthermore, the environmental impact of oil sands extraction continues its technologically driven march towards lower environmental impact per barrel of oil extracted as operators shift from open pit style surface mining towards steam and chemical based drill extraction techniques.
Because of the above listed factors, we can reasonably assume that extraction from the Canadian oil sands will continue for years into the future but knowing whether or not this particular spin-off will be profitable for investors will require further analysis. Again, we will have to review the spin-off companies debt load, capital structure, and price before making any decision to invest or not to invest.
TotalEnergies will almost certainly offload some debt with the spin-off as the transaction offers them an irresistible opportunity to clean up their own balance sheet. If the debt is onerous it could set the spin-off up for bankruptcy and restructuring much like Honeywell’s Garrett Motion spin-off and further delay the investment opportunity until after the company is properly capitalized. Much of the company’s financial viability will of course be a product of the oil price at the time of the spin-off. The Canadian oil sands have a higher production cost than do standard drilling operations, so a low oil price will put the operation at risk where a price above about $70 per barrel or more would allow for a profitable operation.
As to price, we suspect the spin-off will trade at an attractive valuation simply because the industry is subject to a global, intense, and focused anti oil movement. For investors this is where the opportunity lies. Whenever a company like TotalEnergies decides to spin something out not because of business fundamentals but instead because the business is out of alignment with their moral principles you have a rare opportunity for price and value to diverge.
It’s worth looking at a few of TotalEnergies climate related statements before we wrap up just to understand their level of commitment to divesting oil and gas. A few of the statements from their last annual report include:
In 2020, in line with its new Climate Ambition announced on May 5, 2020, which aims at carbon neutrality, TotalEnergies had reviewed its oil assets that could be qualified as “stranded”, and therefore had decided to impair its oil sands assets in Canada.
TotalEnergies’ ambition is to get to Net Zero by 2050, across its production and energy products used by its customers (Scope 1+2+3), together with society.
A resolution presenting this ambition to get to Net Zero and its 2030 targets was approved by the Combined Shareholders’ Meeting of May 28, 2021. It also states TotalEnergies’ principles for capital expenditure allocation:
TotalEnergies evaluates the solidity of its portfolio, including new material capital expenditure investments, on the basis of relevant scenarios. Each material capex investment, including in the exploration, acquisition or development of oil and gas resources, as well as in other energies and technologies, is subject to an evaluation that takes into consideration the objectives of the Paris Agreement.
In order to evaluate the resilience of its portfolio, TotalEnergies works on the basis of a long-term oil and gas price scenario compatible with the objectives of the Paris Agreement. As described in note 3.D “Assessment Impairment”, the price trajectory retained for oil by the company for the computation of its impairments converges in 2040 towards the $50/b price retained by the IEA’s SDS scenario. From 2040, the price trajectory converges towards the price retained in 2050 by the IEA’s NZE scenario, i.e. $25/b; the prices retained for gas stabilize, stay until 2040 at lower levels than current prices, and converge towards the IEA’s NZE scenario prices in 2050.
It’s interesting to note, not only the strength of TotalEnergies climate commitment, but also their precise oil price predictions for decades into the future. Any company that can so accurately predict future prices would probably do better in the futures market than in the energy business. All joking aside, there are so many complex interrelations in markets that any price prediction is almost guaranteed to be wrong. We can know with some certainty that oil and gas will remain a key element to global energy markets for decades to come but accurately predicting prices across those decades sets you up for some very unsound business decisions. With any luck for us investors this ideological spin-off will turn out to be a great investment and as always we’ll keep you updated as the thesis plays out.
With that we hope you enjoyed another episode of Special Situation Investing. Please consider sending us a boost on Fountain if you received value from this episode or consider switching to fountain via our affiliate link if you haven’t already switched to this better form of podcasting and peer-to-peer value exchange.
TotalEnergies spin-off (TTE)