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Navigating change in the energy sector

Posted by on 25 September 2017
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The energy sector is at a critical point of change but its transformation creates opportunities for investors.

Jason Cheng, co-founder and managing partner of Kerogen Capital, said this change was throwing up a range of winners and losers.

He pointed out that energy is one of the largest industries in the world, offering a large and diverse opportunity set.

It is also one of the key pillars for global prosperity and global growth, SuperReturn Asia 2017 heard.

Cheng added that there are currently 1.26 billion people without access to energy, but this figure is projected to reduce to just 0.5 billion people by 2024, with much of the growth in energy consumption happening in Asia.

“Change has been brought about by technology, regulation and changes in consumer habits and preferences. This creates winners and losers and opportunities to profit,” Cheng said.

Giving an overview of the sector, he said the oil price had collapsed from more than USD110 per barrel to just USD50 per barrel today, largely due to innovations from technology, such as horizontal drilling and hydraulically fracturing the rock to release hydrocarbons that were previously inaccessible.

"This has increased supply and made around half of the world’s planned extraction projects uneconomical."

At the same time, he said there has been a rapid cost fall in solar and wind power, leading to rapid growth in solar and onshore wind generation.

“That growth is expected to continue, largely at the expense of coal and nuclear,” he said.

Cheng said there were different ways for investors to approach different segments of the industry, according to the particular dynamics at play given the change that is taking place.

“Coal and nuclear have a shrinking market share but it is still the mainstay of energy in China and it is still generating a lot of cash flow as coal prices have gone up,” he said.

“The risks are the time horizon and exit, but if you are looking for an unloved industry that is generating good cash flow, this is one.”

Within oil and gas companies, he said players at the high end of the cost curve had fallen out of favour compared with those at the low end of the cost curve.

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Identifying winners

Cheng said the key factor for investors was whether companies could be fast enough to instigate change.

“Often large corporates struggle to make that change because they are usually dealing with too many legacy issues. The key is ensuring you can select the right assets and the right players,” he said.

"Meanwhile, renewables are growing and expanding in market share, but he warned they should not all be treated the same."

“Solar and wind are now proven technology, the supply chain is commodified, a lot of capital is rushing into the system and, therefore, entry pricing is becoming a bigger issue,” he said.

But he added that other types of renewable energy, such as offshore wind and geothermal, were still in their infancy and it was difficult to see who would be the winners and who would be the losers.

Cheng said Kerogen Capital had found more profitable opportunities during the fall in the oil price than when it was at USD100 per barrel.

“We have seen value unlocked through distress, with too much leverage in the system, which has led to quite a lot of restructuring opportunities within the industry,” he said.

He added that there had also been a capital flight, leading to a lot of high quality projects without funding available.

“This has provided some of our best opportunities,” Cheng said.

There has also been consolidation, with larger oil and gas companies focusing on newly defined core strategic areas, resulting in a lot of assets coming up for sale which are deemed non-core.

Cheng said cost structure deflation, as a result of the fall in the oil price had also enabled investors to capture quite a lot of value with much less capital at risk.

Selecting the right assets

But he stressed that it was important to develop an investment strategy that worked in a cyclical industry.

“The key is to make sure you have assets which are at the low end of the cost curve, because that is the only thing you can control if you can’t control your price,” he said.

He added that this meant using a different type of selection criteria for the assets you focused on, with no ‘break evens’, which mean high margins, as well as having low leverage and entry price discipline.

“Of course, if you have good assets and good teams and a strategy focused on operational value-add then you are dealing with relatively safe assets, and commodity price reversion or appreciation is separate to your thesis,” he said.

“If you get it, great. If you don’t, you are still making good money.”

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