Australian investors have a dilemma. Do they invest in undervalued energy names that pay handsome dividends or join the growing number of banks, pension funds and investment managers ditching the sector?

The debate is being fought on ground familiar to investors: risk. For fossil fuel bulls, it's the risk of missing decades of returns as oil and gas (O&G) companies service energy hungry Asian markets. For bears, it's the risk that billions sunk into rigs and refineries fail to deliver returns to shareholders, instead becoming stranded assets a renewable energy-fuelled future no longer needs.

Both fossil fuel bulls and bears acknowledge a day when the last oil rig is decommissioned but disagree when it will occur. That gap is measured in years and hundreds of billions in potential earnings.

Morningstar spoke with a range of analysts and fund managers to find out what growing energy demand in Asia means for fossil fuels, how the rise of new technologies threatens early obsolescence and the prospect of the O&G industry transitioning to a green future.

Bulls look to the Asian ‘juggernaut’

The World Economic Forum forecasts that the Asian middle class will grow by 1.5 billion people this decade. Change brings transformations in how people live. What does that mean for Australian energy providers? More demand for oil and gas, says Mark Taylor, senior equity analyst at Morningstar, especially for Australian natural gas.

Since the industrial revolution, economic growth has gone hand in hand with burning fossil fuels. Korea and Taiwan are just two examples. In these two Asian powerhouses, energy use per capita grew in line with GDP as they developed the International Monetary Fund shows. Economies do eventually reach a point where they can grow without consuming steadily more energy, for example energy use in the US or UK has plateaued even as wealth increased.

But emerging economies such as China and India—which are also among the world’s largest polluters—are not at that point yet. US GDP per capita is six times higher than China and 27 times India, and that energy demand will continue to grow, according to Taylor.

As this demand grows, there will be a temptation to build cheap and familiar coal or natural gas plants, says Taylor. These plants are still cheaper upfront than large-scale solar or wind, even if ongoing costs are higher.

“We’ve got this juggernaut of billions of people coming into wealth, and energy consumption is growing. They’re not yet in an income bracket where they can afford wind turbines and solar panels,” he says.

Australia’s proximity to Asia and relative political stability mean customers are often willing to pay a premium to lock in supply of the domestic natural gas extracted by players such as Woodside (ASX: WPL).

Criticism is growing ahead of the upcoming investment decision on Woodside's $US11 billion proposed gas field off Western Australia. A coalition of groups including think-tank The Australia Institute have blasted the project as inconsistent with keeping global warming below 1.5 degrees.

Taylor’s fair values for local natural gas players Woodside and Santos (ASX: STO) incorporate his assessment of risks to material shareholder value destruction from environmental, social and governance (ESG) factors.

Last year China made waves with a commitment to net-zero emissions by 2060. But that pledge was cast into doubt in June this year following a report by Carbon Tracker . The independent think tank found that China featured among several countries, including India, Indonesia, Japan and Vietnam, that were planning to build a combined total of 600 coal power plants.

Almost 100 per cent of global coal capacity will be more expensive to run than renewables by 2026, according to Carbon Tracker.

Reliability and a way to cut emissions in the short term

Even where renewable energy is cheaper, power plants run on fossil fuels give energy grids reliability. They can be turned on and off quickly to meet energy demand. Wind or solar energy is intermittent, available only when the sun is shining, or the wind is blowing.

In Europe, where utilities are closing coal plants and investing heavily in renewables, intermittency remains a problem, says Tancrède Fulop, a Morningstar senior equity analyst based in Amsterdam.

“It will not be feasible to have a full renewable energy system [in Europe] by the end of the decade,” he says.

Bulls argue the push by governments in Asia and elsewhere to cut emissions could initially benefit some fossil fuels such as natural gas. Developing countries can cut emissions by switching to natural gas instead of more carbon-intensive forms of energy such as coal, lifting natural gas demand in the process, says Taylor.

The 2020 BP Energy Outlook modelled three decarbonisation scenarios. The middle-ground “rapid” option projected Indian net O&G imports doubling by 2050 and the primary energy share of natural gas increasing to 2035.

Even if Asian economies meet their current aggressive renewable targets, natural gas will still be required, says Aaron Binsted, a portfolio manager at Lazard Asset Management.

“Our demand scenarios for gas are predicated on these nations meeting their very aggressive renewable targets, like China’s 2060 net zero target,” says Binsted.

“And there are informed voices who say these Asian nations are going to struggle to meet their targets, that they’re a little too aggressive and have assumed lots of new technologies.”

Fossil fuel bears have heard it all before

Sustainable asset managers such as Tom King says fossil fuel bulls have gotten it wrong before . In the past decade, mass production, and technological innovation took solar and wind from being “totally uneconomical” to one the cheapest forms of energy today.

“Naysayers will say that you can’t run the global economy without oil and gas and that’s true now, but it won’t be true soon,” says King, chief investment officer of neutral-rated Nanuk Asset Management.

Bears like King are counting on new technologies such as green hydrogen and batteries to turbocharge large-scale renewables adoption. Help will also come from state subsidies and the tightening noose of emissions regulations.

Battery technology is mainstream and a viable way of solving the intermittency issue with renewables, according to Morningstar senior equity analyst and electric vehicle specialist Seth Goldstein.

The costs of battery technology have plunged, falling 97 per cent since 1991 according to Our World in Data. Further falls are coming thanks to the economies of scale from giant factories being built by the likes of electric vehicle maker Tesla (TSLA), says Goldstein.

These factories are designed for the so-called EV revolution, but Goldstein says car batteries can easily be scaled up to utility-size scale.

“We’re seeing renewable projects with a battery starting to become more popular as the utilities build more renewables.

“This is likely to become the mainstream way that utilities build out renewable projects.”

Hydrogen is attractive because it can be stored, is more energy dense than natural gas and has water as its by-product instead of greenhouse gases. Most hydrogen today is “grey”, produced using natural gas, advocates want to use renewables and turn it “green”.

Green hydrogen is not economical yet but investment is building. The Hydrogen Council, an industry lobby group, expects at least $US300 billion in public and private investment through 2030. In June, the US Department of Energy announced plans to cut costs for green hydrogen by 80 per cent this decade.

Both battery and green hydrogen technology will hope to follow the example of solar and wind, whose costs fell 89 per cent and 70 per cent, respectively, in the 10 years to 2019.

The combination of cheaper batteries in the short term and green hydrogen in the long term means that even gas faces multiple headwinds, according to Pablo Berutti, an investment specialist at Stewart Investors.

Stewart Investors secured the top Morningstar ESG commitment level rating of “Leader” in 2020.

Government policy is another obstacle for fossil fuels, say bears, one that will only worsen. They expect governments to use tariffs, subsidies and legislative targets to encourage the adoption of renewable energy. They foresee carbon taxes and strict regulations putting up obstacles for fossil fuels.

In 2019, the UK passed legislation committing it to net-zero emissions by 2050; Carbon border tariffs, which would penalise goods produced in countries without carbon prices, are planned in the EU; China is moving to phase out pure internal combustion engine cars; and in a July report, the International Energy Agency, said no new O&G fields were required to get to net-zero by 2050.

All the bulls Morningstar spoke with agreed that government action, especially carbon taxes, was the major risk for their forecasts. But they don’t see them being introduced at sufficient scale or price, especially in Asia.

Fossil fuel bears deny their arguments only apply to the developed world. Tom King concedes natural gas demand will increase in the short term but not enough for the multi-decade lifespan these assets are built for. There is a serious risk they are underutilised years before expected, he says.

It’s a question of financial risk not ethics, says Tim King, chief investment officer at freshly launched impact investment fund Melior Asset Management. Fossil fuel assets risk being stranded–unexpectedly written down or devalued–at a loss to shareholders.

“Are they fit for purpose in a Paris-aligned world?” King says, referring to the Paris climate accord. “These questions are getting far more airtime and I think we’ll see more of that.”

“It's going to have consequences for share price performance.”

For investors interested in the sustainability theme, Morningstar likes several names in the electric vehicle space, including auto supplier Borgwarner (BWA). For those wanting exposure to hydrogen, Morningstar likes names including industrial gas supplier Air Products (APD).

Can O&G firms transition to a green future?

Andrew Forrest made billions at the helm of Fortescue Metals Group (ASX: FMG), the world’s fourth-largest iron ore exporter. But last year, he criss-crossed the globe for months signing billions in green energy deals, including the world’s largest hydropower project in Africa.

Forrest isn’t alone in his conversion from natural resource baron to green energy disciple. Shell (RDSA) plans to be net zero by 2050. The CEO of Total (TTE), one of the world’s largest O&G companies, wants the company to become a green energy major. Woodside is proposing a renewable hydrogen project in Tasmania, next to one proposed by Fortescue.

It’s been done before. In 2008 Danish energy company Orsted (ORSTED) generated 85 per cent of its power from coal. Today, 90 per cent of earnings come from offshore wind farms.

Closer to home, utility AGL (ASX: AGL) is repositioning itself for a renewable future by splitting its coal assets into a separate company. It’s an approach Hamish Douglass, head of Magellan, recently likened to “passing the buck”.

But bulls and bears agree business transformation won’t be easy. They cite technological problems, the existing portfolios of oil rigs and gas refineries and opposition from shareholders leery at the uncertain returns of new expenditure.

The surge of old and new players into renewable energy is crowding the sector and returns are under pressure, says Morningstar O&G sector strategist Allen Good.

“A large part of the investment case in O&G is the dividend. If they’re cutting that to move to a low return highly competitive industry, investors don’t want to underwrite it,” he says.

Morningstar recently stripped Shell of its narrow moat following the company’s strategic shift to renewables, says Morningstar director of equity research, ESG, Adam Fleck.

“While admirable from an environmental standpoint, we have to acknowledge that the moat-building prospects of this move are more limited for Shell, given its strong operating and capital cost position in traditional oil production.”

Fossil fuel bulls and the industry they back are often portrayed as living in the past, but their livelihoods depend on their ability to navigate a volatile future. Like the bears, they're focused on the future, with big bets riding on it.