Environment, social, and governance factors have been playing an important role in commodity markets since long before the term “ESG” became popular. Policies over the years have included standards for automotive emissions, efficiency, and renewable energy fuel content, as well as renewable fuel mandates for power production and direct carbon taxes and cap and trade for manufacturers. The most recent and salient policy for markets is the International Maritime Organization’s global mandate to migrate from 3.5% sulfur in global shipping fuels to 0.5% sulfur. Such policies targeting emissions reductions and fuel efficiency standards have significantly altered supply, demand, and pricing in the commodity markets, creating both risks and opportunities for active investors. While ESG-related considerations and the commodity markets have long been intertwined, growing investor awareness of ESG concerns, as evidenced for example by the theme of the 2020 World Economic Forum in Davos, has made them central to capital allocation discussions.

One common thread to the aforementioned policies has been the stated intention of policymakers to weaken hydrocarbon demand, particularly for petroleum and coal.1 These policy-driven impulses, along with recent improvements in new energy technologies such as electric vehicles and declining prices for renewable power sources, have greatly depressed sentiment among many market participants about the future of hydrocarbon demand, raised the specter of stranded producing assets and depressed expectations for future prices.

Further, concerns about the future of hydrocarbon demand stemming from environmental concerns – along with the realization by some that most oil and gas producers generally have not been good stewards of capital or sufficiently reoriented their business models to a low-carbon economy – have driven both public and private capital away from the oil patch. Drilling levels have dropped to two-year lows (according to Baker Hughes), and capital budgets are being slashed as investors begin to demand better governance from exploration and production (E&P) companies. Many pensions, endowments, and sovereign wealth funds are divesting upstream producing assets. The net effect of this flight of capital is evident with the energy patch share of the S&P 500 falling to the lowest level in over 20 years. In some respects, the distress in the U.S. E&P patch is not unlike what was witnessed in 2016 when prices were half the level of today; looking ahead, the upcoming debt maturities of E&P companies over the next three years raise questions about the viability of their business models. Even the European Investment Bank announced it will no longer fund projects producing or consuming hydrocarbons after 2021.