Strange Bedfellows - Super cycle in renewables and oil & gas

The super cycle in renewables is in full flow and, perversely, oil and natural gas will remain a beneficiary until sufficient new renewable capacity is created.

The current renewable energy solutions of solar and wind are estimated to be some 10 times more metals intensive then the fossil fuel plants they are replacing. The life cycle of the current renewable solutions are substantially less than a typical coal or nuclear power station which last 30-50 years. The critical minerals required for global decarbonisation include rare earths, lithium, cobalt, copper and nickel. The world currently does not have sufficient reserves to fulfill the net-zero aspiration. Therefore, we expect prices will remain elevated, with Australia in a pivotal position given our resources inventory to help deliver on the energy transition (refer Tyndall's ESG Insights: The value in securing critical minerals).

Oil development is down substantially, with cashflow from the major integrated oil and gas companies spent on buybacks, natural gas and renewable projects like solar, wind and hydrogen. Shareholder activism and government pressure have contributed to oil producers reducing capex and development spend. Traditionally, there has been a tight relationship between oil prices and drilling/development. This relationship appears to be broken, and even in the short cycle unconventional prospects onshore in the USA, companies are drilling less despite the attractive economics.

Given oil reservoir production typically depletes by 10-15% p.a., there appears to be a substantial supply gap going forward, despite demand decreasing. Norwegian oil and gas consultant - Rystad, estimate that 61m barrels of oil per day need to be developed by 2030 when using the 1.7-degree scenario (refer Figure 1).

Figure 1: Demand for oil outstrips supply

Source: Rystad

The three horseman of the apocalypse — energy, interest rates and labour cost

Increasing energy, interest rates and labour costs are substantial headwinds for many companies and as margins continue to come under pressure, we expect downgrades throughout 2023. Labour pressures are being felt in both wages and from the global impact of apparent labour shortages. Given this is felt across various sectors, it is difficult to envisage a short-term fix outside of a substantial economic downturn.

The impact of monetary policy tends to lag by 12-18 months, meaning the Australian economy is yet to feel the full impact of tightening monetary policy. Full employment and an above-average savings rates have softened the impact. The wealth impact of housing weakening further in 2023 will eventually put the brakes on consumption. The canary in the coal mine during slowdowns driven by interest rates is normally a discretionary consumer pullback. Consumer discretionary sales currently remain high with little evidence of pain felt by retailers. We expect commentary in the February 2023 reporting season may provide some early signs of both margin and top line growth pressures.

The combined impact of the materially higher cost inputs of energy, interest rates and labour should become clear over 1Q 2023. Margins are currently at high levels, and we expect pressure, particularly in companies and industries that have little pricing power to fight the inflationary forces. We see little respite in energy and labour outside of government intervention, whereas interest rates may roll over when Central Banks consider they have the inflation under control.

Be prepared for the profit downgrades.

China — exiting COVID Zero

The changes observed over the past 20 years of visiting China have been incredible given the combination of a growing middle class and high annual GDP growth. The Chinese Communist Party (CCP) is cautious to not upset the mass population. This is in contrast to an outsider's view which tends to believe China's people are frightened of the CCP. The catalyst for the recent COVID pivot from the CCP over COVID restrictions were the large demonstrations, often violent across China, from citizens frustrated by the restrictions. Interestingly, western governments ignored and, at times, violently pushed back on similar demonstrations. The CCP has now relented and recently announced 10 optimisation measures that mark the tipping point of the country's economy reopening.

Therefore, in 2023 we are likely to see China go through a typical reopening phase similar to what we have observed across most western countries, resulting in consumption and GDP increasing. Australia may be a beneficiary of China reopening as consumption and demand increase. Both services and materials demand will rise, with oil and natural gas being a notable beneficiary.

Recession risk rears its ugly head

The aggressive tightening of global monetary policy aimed at slowing the economy is likely to move many countries into recession territory. It appears to be a fait accompli that Europe and the UK will dive into recession, and the debate is still ongoing on whether the USA will dip into negative GDP growth. Australia has the benefit of the world desiring its resources and agricultural products, and thus the probability of a recession appears lower, albeit in many ways this is just semantics given a slowdown is coming.

Inflation and interest rates — the return of the "old normal"

Inflation will reduce as COVID supply chain issues and the Ukraine war impacts alleviate. However, inflation will remain stubbornly higher compared to the past 10 years given obvious structural changes including labour shortages, persistent supply chain disruption and constrained supply of some goods. Technology innovation and productivity will need to accelerate to offset these pressures. Demographics, meanwhile, are negative for many countries, with a slowing population, particularly within advanced countries including China. Australia benefited prior to COVID with strong immigration but, overall, the combination of increasing demand (consumers) and decreasing supply (workers) is not great arithmetic. Global demand for labour currently is high.

We hope central bankers have learnt their lesson, given they kept monetary policy too low for too long and entered COVID with very low interest rates. It is difficult to envisage interest rates being that low outside of an emergency, meaning higher interest rates are here to stay.

The net result is that higher interest rates and inflation imply that long duration assets should further derate.

Getting deglobalisation right

Globalisation, together with China essentially selling deflation to the world over the past 20 years, will pause and perhaps even retreat. Companies and countries have recognised that relying on single supply chains or countries is risky. COVID and the Ukraine War have illustrated these risks, and we are starting to see governments develop plans to mitigate these risks.

In one example, new chip manufacturing plants are being built in the US and governments are helping to fund the critical minerals required for the pathway to net zero. Additionally, the Australian Government provided an AU$1.2b non-recourse debt facility to Iluka Resources to help fund their rare earths processing facility in West Australia. This was unprecedented for the Federal Government and illustrates how countries are viewing the access to reliable and secure supplies of critical minerals.

Most recently, the US passed the Inflation Reduction Act of 2022 (IRA), which directs nearly US$400b in federal funding to clean energy, with the goal of lowering carbon emissions by the end of the decade. There are strings attached, with many of the IRA tax incentives requiring domestic production, domestic procurement requirements or from a country with a free-trade agreement. Australia could be a beneficiary of this given our relationship with the US, which includes a Free Trade Agreement.

The bottom line is that deglobalisation is inflationary and will continue placing pressure on inflation for many years to come.

Value investing makes a big comeback

Tyndall has always viewed value investing as a philosophy rather than a factor. Our process has always aligned with the approach from Benjamin Graham, the father of value investing. Tyndall values companies based on their sustainable earnings capacity. We determine the intrinsic value by capitalising the sustainable or mid-cycle earnings of every stock under coverage. At its core, value investing is buying companies that are trading below their assessed net worth, maintaining a disciplined and patient approach.

The valuation gap between growth and value remains at extraordinarily high levels despite a recent narrowing (refer Figure 2 & 3). The tailwinds for growth post the GFC are unlikely to return anytime soon. Higher inflation and interest rates are here to stay, and thus we expect the elevated valuations still being priced for growth will derate further. A disciplined and bottom-up valuation approach will deliver alpha during these times.

Figure 2: High PE firms trade at a 75% premium to the market - well above historical averages. US LNG capacity forecasts

Source: Goldman Sachs

Figure 3: Value on track to outperform over the next few years

Source: MSCI

Author: Brad Potter, Head of Australian Equities

January saw property prices fall nationally by 1%, which was less than December and the smallest month to month decline since mid last year according to CoreLogic's national Home Value Index.

Prices fell across all capitals by an average of 1.1%, however regional housing values continued to record a milder rate of decline at -0.8%. Hobart saw the largest reduction (-1.7%), followed by Brisbane (-1.4%), Sydney (-1.2%), Melbourne (-1.1%), Canberra (-1.0%), Adelaide (-0.8%) while the falls in Perth and Darwin were less significant at (-0.3%) and (-0.1%) respectively.

The quarterly trend however is pointing to a reduction of the in the pace of decline, and despite the falls every capital city and region is still recording home values above pre-pandemic levels.

Contributing to the reduction of dwelling values, is the fall in demand. Capital city dwelling sales were down -29.4% on previous year figures, with listings -22.2% below the same time last year meaning that most home owners who are considering selling are sitting things out with no pressure to sell into this market.

Weekly auction activity has begun to increase in 2023, with 706 auctions taking place across capital cities last weekend achieving a 67.9% clearance rate which we consider positive. Melbourne recorded the most auctions with 259 auctions taking place at a clearance rate of

68.3% (67.5% last year), followed by Sydney with 202 auctions and a strong clearance rate of 71.6% (66.3% last year). Adelaide achieved the best clearance rate for the weekend with 76.8% (81.8% last year) for their 105 auctions whilst Brisbane and Canberra were lower with clearance rates of 59.6% (80.1% last year) and 52.2% (85.5% last year) respectively.

Whilst property prices will undoubtedly be linked to the movement in interest rates we do believe we are nearing the end of the rate rise cycle, with some banks already beginning to reduce the fixed rates for 3 and 5 year terms.

The resurgence in overseas student migration will also see the rental market remain tight and help support yields across the residential property market. As a result we do believe housing values will stabilise over the coming months as some level of confidence returns to the market. 

Quick Insights

The Return of Students  Demand is set to strengthen in inner-city suburbs across Australia as the Chinese government directs its students to return to university campuses worldwide. Almost 50,000 Chinese students are expected to flood back into Australian capitals looking for rental accommodation as they return to in-person study. This injection of demand is likely to raise rental yields by at least 5%

Extra Eastern Income  Demand for rentals in Sydney's affluent eastern suburbs never waned throughout last year even as the supply of suitable housing dried up. As a result, an additional $19,812 in rental income was delivered to some landlords throughout 2022. Across the country, houses and units across 195 suburbs made at least $5200 a year in extra rent during the same period.

Apartments Continue to Rise  In addition to the rental apartment frenzy in Melbourne and Sydney, property prices among apartments have also risen. In particular, Adelaide, and Brisbane have seen unit values jump by significant amounts. 76 suburbs across Queensland and South Australia, broke record-high prices in December. Adelaide's Mitchell Park alone rose by more than 30%. Tim Lawless of CoreLogic has explained that, "...with borrowing capacity reducing as interest rates rise, it's likely the lower price points of unit values have become more broadly appealing."

As we look forward to the year ahead, we have been reflecting on where we are likely to see the most prominent sustainability issues (sometimes called 'ESG' or environmental, social and governance issues) surface for companies in the year ahead.

Our predictions include continuing to see the big issues, such as climate change, remain centre stage but shift from a conversation about disclosures and targets to issues of quality and substance. Alongside climate, we will see companies scrambling to make sense of an expanding environmental mandate to include understanding their implications on nature and biodiversity more broadly.

We see a big year ahead for social topics, including industrial relations and labour rights, as well as a resurgence of issues pertaining to social license to operate. And, as ever, good governance will continue to be a key driver of value, particularly with the continuing rise of cybersecurity issues and companies having to navigate an increasingly complex landscape of material issues.

Our predictions for the big battleground ESG issues for the year ahead are:

Environment

1. Climate change issues are evolving towards quality:

• Move toward the improved transparency, rigour, feasibility and quality of emissions reductions strategies, including a focus on more science-based targets and disclosures for scope 3 emissions.
• Push for reducing greenwashing and more scrutiny around credibility of targets and claims, as supported by the Treasurer recently putting greenwashing penalties into focus, and signals from ASIC and APRA over the last year that guidelines are moving toward increasing regulation and penalties. This is also supported by the establishment of the Australian Sustainable Finance Institute and their move to publish an Australian Sustainable Finance taxonomy.
• Negative emissions - taking carbon out of the atmosphere, not just avoidance and abatement-will become a hot topic.

2. Nature, food and water security and biodiversity will be the newest everywhere topic:

• 2023 will be a year of companies trying to establish their liabilities and obligations with the growth in nature-related disclosures.
• Beyond 2023, clearer standards and expectations will emerge in relation to the way companies are impacting vital resources, like water, soil and air, biodiversity. This will be underpinned by tightening Federal legislation (e.g. Our Nature Positive Plan) and increasing disclosure frameworks (e.g. TNFD (Taskforce for Nature Related Financial Disclosures)).
• We can expect more focus on water stress and food security, including on equity and pricing which will have implications on how companies consume, price and manage water assets. The tension between water as a commodity versus a resource as well as issues of access, affordability and sustainability across food supply chains will become increasingly apparent.

Social

3. Industrial relations and labour rights and conditions will become increasingly material:

• Workplace issues will continue to make headlines, including companies that are failing to engage in appropriate cultural shifts to account for demands for diverse, fair and inclusive workplaces.
• Industrial Relations reforms (e.g. Secure Jobs, Better Pay 2022) have put rights for collective bargaining, flexible work, gender equity and zero tolerance on sexual harassment into the spotlight. We see increasing risks for companies with either no EBA (enterprise bargaining agreement) or an EBA set to expire, a low-paid workforce and high union membership, as well as companies with poor track records responding to inappropriate workplace incidents at risk.
• Best places to work studies starting to show that companies that rate highly are driving alpha.

4. Social license to operate makes a 'comeback':

• Greater regulatory pressure and scrutiny on social license when evaluating new approvals. Evidence is particularly prevalent in the mining, materials and energy sectors, with material financial impacts. We are also seeing companies with track records of breaches experiencing regulatory approval issues compared to peers (e.g. RIO v. BHP and FMG).
• Industries and companies with shaky license to operate are more at risk of stakeholder outrage and penalties, NGO engagement, increased scrutiny, regulatory intervention, litigation, and accountability on stakeholder management issues. Socially controversial sectors are likely to see more stakeholder backlash incidents in the years ahead.
• We are also likely to see this issue intersect with issues of equity, access and affordability. As rising cost of living fuels pressures on quality of life, there will be focus on accessibility and affordability as the socioeconomic divide widens, particularly for products and services that are considered 'rights' (e.g. pharma).

Governance

5. Data security and privacy evolves to include issues of data sovereignty:

• The conversation around privacy and data security will continue to escalate, alongside more sensitive data leaks and cyber security attacks. Reports of cybercrime were up 13% in 2022 led by the highest reporting sectors of government (healthcare, IT, and education and training).
• There will likely be pushes toward data sovereignty and people demanding ownership rights over their own data.
• With the rise of AI (Artificial Intelligence), a new suite of digital security challenges such as how data use is intersecting with issues of human rights is quickly surfacing. This is giving rise digital sovereignty issues, where companies will have to navigate geopolitical boundaries to comply with new regulations about data privacy and regulations.

6. The 'G' factor will drive corporate responses to an evolving landscape of material issues:

• While corporate governance has been the most steadfast in the ESG conversation, we will see the 'G' factors continue to be seen as critical (perhaps the most critical) in this evolving landscape of complex and material E and S challenges. How a company responds to any material issue always comes back to its governance.

Beyond the E, S, and G

Beyond the individual issues surfacing under the E, S, and G banners, we also see trends toward positive investment opportunities, including:

7. Scale will be the focus for the new wave of purpose driven capital:

• Purpose driven capital will move toward opportunities at scale commensurate with the size of the social and environmental challenges and the urgency and timelines of these challenges. Offshore wind, hydrogen, nuclear-what are the game changers that are going to help address the scale and urgency of the problems we are facing? This is where the ideal moves toward the pragmatic and money will follow, which is why we are seeing labelling shifts in the EU Taxonomy to allow for gas and nuclear.
• We will see the theme of 'transitions' extend beyond energy and climate. The trend of moving away from 'divestment' toward active engagement will start extending to other sectors including waste and toxic chemicals. This provides opportunities to look at positive screens and ESG improvers and leaders across all sectors, particularly those companies with entrenched social/environmental issues but which are societally necessary or difficult to replace.
• Collective action and collaborative engagement will be a feature for engaging in these strategies. We expect to see new innovative approaches toward collective action in the year ahead.

8. Sustainability, ESG and Impact are no longer distinct approaches to investing:

• Investors across all shades of responsible investment have been looking for the win-win solutions to back for decades, opportunities that deliver alpha and support the narrative of addressing our world's most pressing social and environmental challenges. Investors now seeking to align a values overlay with value considerations have to look beyond the thematic to the nuance of how companies are operating. This is forcing a "coming together" of ESG considerations with positive screens, thematic investing and impact investing. This is, in part, because value is not just driven by what a company produces but also by how it operates. This means that a lot of our distinct responsible investment approaches are blurring together, creating a greater need to help investors interrogate the different strategies of how managers are integrating these responsible investment considerations into investment decisions. This intersects with the moves toward a taxonomy, scrutiny around greenwashing, and greater requirements for transparency, disclosures, and language that helps investors understand the quality of disclosures and strategies.

Author: Dr Erin Kuo, Yarra's Chief Sustainability Officer