The war in Ukraine—and ensuing high oil and gas prices— has spurred debate over whether investors should position for higher oil and gas prices or the transition to clean energy. Here’s why they should consider both.
Prior to the war in Ukraine, most discussions around energy focused on energy transition—specifically, how the world could meet its growing energy demands while weaning itself off fossil fuels.
Within a matter of weeks, however, investors turned their attention to energy security—as the war drove up oil and gas prices and prompted governments to prioritize immediate energy needs over the longer-term transition to clean energy. Not coincidentally, as energy prices soared to near-record highs, renewable energy shares sank.
“This is a false choice,” says Stephen Byrd, who heads North America Power Utilities and Clean Energy Research. “We think policymakers will continue broad-based support for the adoption of renewables, electric vehicles, carbon capture and other technologies while ensuring secure traditional energy sources.”
In late 2021, when oil was trading around $70 a barrel, Morgan Stanley analysts covering multiple industries did extensive research on the energy transition and its implications. Their initial report, “Turbulence of the Transition,” forecasted significant volatility in energy markets over the next decade as global energy demands outpace supply—until clean energy is available at scale.
“On the other side of the energy transition lies a new, stable system, but the journey between here and there looks to be a turbulent one," says Martijn Rats, Morgan Stanley's Commodity Strategist.
For investors, the current geopolitical environment creates an interesting, if somewhat conflicting dynamic. “We think traditional and renewable energy winners can benefit from greater onshoring and higher energy prices, as well as continued support for renewables,” Byrd adds.
Here are some of the longer-term dynamics driving the energy transition and related themes, which include everything from demand outlooks and divestment trends, to the feasibility of energy alternatives and carbon sequestering.
Climate change is the key factor driving the global energy transition. The math is straightforward. In order to limit further warming to below 2 degrees Celsius, the world needs to achieve Net Zero — a point when any greenhouse gases produced are offset by taking emissions out of the atmosphere — by 2050. Getting to this point will require significant change in the use of fossil fuels. In fact, the International Energy Agency (IEA) estimates that oil and natural gas use needs to decline by 29% and 10% respectively by 2030, with further strong declines thereafter, to achieve Net Zero by 2050.
And yet, global demand for energy has been steadily increasing as a result of population growth and continued economic development. Even if oil dependence declines, growing global gross domestic product (GDP) suggests global oil consumption will peak around 2033.
It’s important to note that transportation and heating aren’t the only drivers of demand. “Oil, for example, is also used for everything from textiles to sporting goods, and from electronics to medical supplies," says Rats.
Global oil demand is expected to peak in 2033 even as oil intensity declines.
Despite growing demand for oil, gas and related products, institutional investors have been shifting their portfolios away from these sectors.
“Around 235 institutional investors representing some $58 trillion in assets have already committed to align their portfolios with Net Zero," says Jessica Alsford, Global Head of Sustainability Research. “In addition, 92 banks, representing 40% of global banking assets, have promised to decarbonize their lending and investment portfolios, in line with the Net Zero ambition."
Recently, many central banks were considering the "greenness" of corporate bond purchases, while nearly 1,500 organizations, including pension funds, trusts, foundations, family offices, educational institutions and NGOS, accounting for $39 trillion have pledged to divest from fossil fuels and invest in climate solutions.
The energy sector has responded in kind. Investment in oil and gas field development declined from around $740 billion in 2014 to $475 billion in 2019 and took another step down in 2020 to $353 billion. This did not increase materially in 2021.
Prior to the war in Ukraine, Morgan Stanley analysts forecasted that oil production would increase in 2022 and 2023, due to projects that were already underway, then peak in 2024 and decline. Under this scenario, oil markets would be undersupplied, and prices would rise—irrespective of geopolitical shocks.
One of the key questions now is whether the war in Ukraine will spur renewed interest in investing in oil and gas—and how quickly changes in capital and production would hit the market. In the case of U.S. shale, for example, the lag would be six to nine months, and possibly more given logistics and supply constraints.
The war could prompt the U.S. government to incentive additional domestic oil and gas production, but this would likely be met with significant opposition. “Moreover, recent messaging from the administration suggests the focus of energy policy remains on advancing clean energy and moving away from fossil fuels, making pipeline support from the administration unlikely in our view,” says Byrd.
Despite investor and policy support, clean energy still has a long way to go before it reaches the scale needed to support global demand. Some 81% of the world's primary energy supply comes from oil, gas and coal, according to IEA estimates for 2019.
The remaining 19% can be categorized as 'non-fossil, primarily from three sources — nuclear, hydropower and biomass — and each has its own challenges. For example, most of the world's longest rivers already have dams in them, and biomass often competes with food production for arable land. Nuclear power offers the greatest potential for low carbon power, but it's costly and controversial.
Bottom line: Fossil fuels will continue to play an outsize role in energy markets, even if green alternatives come online faster than expected. “In the end, to drive a successful energy transition, both supply and demand of fossil fuels must be addressed," says Rats.
For more Morgan Stanley Research on the energy transition, ask your Morgan Stanley representative or Financial Advisor for the full reports, “The Turbulence of the Transition" (Nov. 8, 2021) and “A False Choice: Energy Transition/Energy Security Is Not Either/Or” (March 9, 2022). Plus, more Ideas from Morgan Stanley's thought leaders.