Creating the perfect critical metals portfolio – buy oil first

Navigating boom-to-bust cycles, which are the hallmark of the resources sector, is never easy but last week one of the world’s leading research houses floated an idea which could help investors with a taste for mining and oil create the perfect portfolio for changing times.

In a nutshell, the concept is to buy oil and gas companies today to share in their windfall profits from a near-record oil price of US$123 a barrel, with dividends reinvested in companies exposed to critical and battery metals.

Wood Mackenzie, a British-based consultancy, which advises some of the world’s biggest natural resource companies, did not directly suggest that strategy in its report but what it did say is open to just that interpretation by individual investors.

Invest record oil profits in critical metals

The oil into critical metals concept is contained in a report written by Wood Mackenzie senior vice president Julian Kettle and meant for consideration by big oil companies which are under pressure to do more about their pollution problem.

His idea is that oil companies might use some of their excess cash to invest directly in critical metal projects, perhaps by partnering with a miner in new developments, or through buying a mining company exposed to metals such as lithium, nickel, cobalt and copper.

At its simplest, the idea makes a lot of sense because oil companies are generating such enormous profits that they have become targets for governments to levy super-taxes (as the UK just did), while the critical mineral sector is screaming for access to the billions of dollars needed to develop essential projects to meet the demands of energy transition.

Past challenges

How a marriage of oil cash with mineral projects might work will require a lot more detail and a willingness of everyone involved to forget the lessons of history which show that past oil-mining mergers have failed.

Most of the oil majors, including Shell, BP and ExxonMobil, have tried to develop mining projects without success, eventually quitting thanks to a clash of corporate cultures and dramatically different capital requirements and investment returns.

The miners too have tried oil and quit. BHP (ASX: BHP) is the last to offload its oil business.

Kettle estimates, in his report titled “Could big energy and miners join forces to deliver a faster (energy) transition”, that oil projects are typically based on a 15% internal rate of return, whereas mines are in the 10%-to-12% range.

Renewable energy projects are in a different league again, offering investment returns in the 5%-to-6% range.

Those capital returns show why it can be tough for renewable energy proponents to raise the capital required to build the solar farms and wind turbines needed to achieve transition from fossil fuels such as coal, oil, and gas.

But behind the financial factors is government intervention in the market with increasingly forceful demands that fossil fuel use be reduced, and renewables become the backbone of the power system as well as transport via a shift to electric vehicles.

Appeal to private investors

While the reaction at an industry level to the Wood Mackenzie theory has been muted it is one which might appeal to private investors creating a mechanism to play both sides in an evolving energy picture.

Investment today in handsomely profitable oil and gas companies such as Woodside Energy Group (ASX: WDS), Santos (ASX: STO) and Beach (ASX: BPT), will expose an investor to the red-hot sector powered by sanctions on Russian oil and gas and concern that even after Russia returns there will be insufficient ongoing investment in new oil projects, meaning prices could stay higher for longer.

But the twist in the strategy is to apply Wood Mackenzie’s idea and use dividends generated by the oil and gas producers to buy battery and critical metal miners such as Allkem (ASX: AKE), Pilbara Minerals (ASX: PLS) and IGO (ASX: IGO).

What’s interesting about applying Wood Mackenzie’s oil-minerals mix is that there is a greater chance of it working for private investors than for oil companies trying to get bigger in metals exposed to energy transition.

Hurdles to clear

Kettle identified two major hurdles to be cleared by his “critical metals acceleration” concept.

“Miners are constrained by investor reticence to sanction faster growth at the expense of dividend, long project lead times, and rising above-ground risk,” he wrote.

“Policy makers (government) are sending the wrong signals, claiming they are open for business and then constraining the development of mining projects that would deliver the metals required. They’re not fully on board to meet the need for a massive expansion of primary extraction.”

Neither of those obstacles can prevent an individual investor from following the plan which is essentially about redirecting capital away from fossil fuels into renewable energy production and critical metal mining.

Interestingly, Kettle acknowledges that National Oil Companies (NOCs) and sovereign wealth funds can “dive into the (critical metals) supply chain without being punished by capital markets”.

“Whether it’s the integrated oil and gas majors, NOCs or mid-caps that lead the charge into metal supply, the one certainty is that investors would benefit from access to mined commodity markets with explosive growth,” he wrote.

“There is the added benefit that this would make a significant contribution to delivering decarbonisation commitments.”

Unsaid by Kettle, but open for private investors to consider is that while companies are challenged by the complexity and a history of failure in trying to mix oil and metals there is nothing stopping a private investor from applying this idea.