Could cheap oil and COVID-19 derail the transport revolution? Not in our view.

investment viewpoints

Could cheap oil and COVID-19 derail the transport revolution? Not in our view.

Kristina Church - Head of CLIC™ (Sustainable) Solutions

Kristina Church

Head of CLIC™ (Sustainable) Solutions

A dramatic transformation is already underway in the transport sector. A powerful combination of regulation, changing consumer preferences and market forces is fundamentally changing demand and supply dynamics for the sector. Historically, a significant fall in the oil price would typically have worked to slow down the transition to clean mobility, by encouraging greater vehicle usage and shifting the cost dynamic away from electric vehicles, but we believe this is no longer the case. Despite the rapid – and likely prolonged - decline in oil prices, we believe the transition to clean transport continues to provide attractive investment opportunities, especially as consumers and governments respond to the heavy economic and social costs of the COVID-19 pandemic.

we believe the transition to clean transport continues to provide attractive investment opportunities

Our climate transition strategy is designed to identify and harness these opportunities by investing in companies that stand to gain competitive advantages or growth opportunities resulting from the long-term structural trend towards lower-carbon transport.

Why history won’t repeat itself

Historically, a prolonged fall in the oil price would have had the effect of boosting overall demand for road transport, and shifting consumer preferences towards more carbon-intensive transport options, such as larger SUVs (sports utility vehicles) and pick-ups. This was particularly the case in the US, where around 50% of the retail price of gasoline relates to crude oil (with the remainder comprising tax, distribution and refining costs) . In Europe, taxation is significantly higher so lower oil prices are not felt so dramatically at the pump.

It may seem intuitive, therefore, that the oil price shock triggered by Saudi Arabia in early 2020 could derail the Climate Transition by promoting carbon-intensive transport. The question for investors is: Will cheap oil shift the price per mile dynamic away from cleaner, zero-emission, shared travel modes (electric, micro-mobility and mass transit) and towards more carbon intensive vehicles? 

We think not. 

the current oil shock will have a limited to mildly positive impact on the transition to lower-carbon transport

At Lombard Odier, we believe the market dynamics for mobility are fundamentally different today: policy support for the transition remains strong; the environment for consumer sentiment looks increasingly complex, particularly in light of the economic damage created by the COVID-19 pandemic; and market forces are improving efficiency and driving down costs for cleaner transport technologies. 

In combination, these forces create a powerful feedback loop that we believe will work to ensure the current oil shock will have a limited to mildly positive impact on the transition to lower-carbon transport.


Policy support remains strong

Regulation is already having a disruptive impact on traditional transportation modes and demand. Transport is a carbon-intensive sector, accounting for around 17% of global GHG emissions. Road vehicles have been a particular focus for policy makers given they emit nearly three-quarters of all transport-related CO2 emissions.

Short-haul transport emissions are already heavily regulated at international, national and local levels, with fleet average CO2 targets, zero emissions zones, congestion charging, diesel bans and parking restrictions already in full force in many regions.

We expect a step up in regulation at a local level to continue to encourage uptake of lower-carbon transportation, such as electric vehicles (EVs). As the global economy recovers from the COVID-19 pandemic, we expect to see an increased policy focus on the damaging impacts of long-haul transportation (such as air, shipping and road freight), especially in light of the impact we believe air pollution can have on immune systems, the risk of respiratory illness, and the airborne transmission of the virus (the subject of a forthcoming analysis of ours) This is likely to drive even tougher policy action across the transport sector broadly.

We also expect to see more and more cities banning combustion engine cars and the dramatic decline in the oil price also creates an opportune moment for governments to cut subsidies for fossil fuels and channel funding towards cleaner mobility solutions as part of their fiscal response to the pandemic.  A large portion of fossil fuel subsidies are directed towards consumers, and therefore their removal will impact gasoline and diesel drivers just as much (if not more) than oil and gas producers and refiners.


Credit changes consumer behavior

We think consumer support for cleaner mobility is strong enough to mitigate the attraction of reduced gasoline prices as the appetite for conscious, greener consumption in most regions of the globe will continue to increase.

Credit is a key component of road vehicle purchasing behavior. In some developed markets as much as 85% of all personal vehicles are purchased using credit. This is aiding the transition to electric vehicles, which may currently have a higher upfront cost but offer attractive returns over the lifecycle.

Because of the predominance of lease purchases in developed markets, consumers are less focused today on up-front “sticker price”. Instead, consumers are focusing more on the “total cost of ownership” (TCO), which is based on the cost per mile of each transport mode over the lifecycle of ownership. For the average US combustion engine car, for example, gasoline currently makes up only around 10% of this cost (15% for used cars). On LO estimates, the majority relates to fixed costs such as depreciation, tax, urban parking costs and insurance.

On a TCO basis, the fall in oil prices should intuitively push consumers towards combustion engines as the value proposition of an EV becomes less attractive in the near term. However, policy action is disrupting this dynamic as fleet average targets for CO2 are fixed at the international level and will penalize auto manufacturers heavily if these targets are not achieved. As a result, car manufacturers still need to sell EVs to avoid heavy fines and are therefore likely to incentivize the sticker price of EVs.

This naturally changes the TCO dynamics for consumers, which is good news for the climate transition, but bad news for the profitability of any auto manufacturers who are lagging in the race to adapt their business models to an increasingly carbon-constrained world. Global automakers are already grappling with the economic impact of mass factory shutdowns as a result of COVID-19 and heavy cash-burn due to high fixed costs. However, they cannot shy away from spending on electrification due to increasing regulatory pressure.

this EV tipping point is not yet fully priced in, which could create attractive investment opportunities

European fleet emissions targets are particularly tough, and even though they may be delayed by a year as policy makers respond to the economic impact of the COVID-19 pandemic, automakers are still working hard to comply. This is likely to continue to impact consumer buying patterns – and thus auto manufacturers’ profitability – in the medium term.


A tipping point for electric vehicles

Even assuming stricter European targets are delayed, gasoline prices remain subdued, and EV incentives decrease, we still expect the TCO of EVs to start to become highly attractive to consumers over the next few years as depreciation levels decline and battery efficiency and cost points improve.

The cost of production of EVs is much more closely correlated to battery cell costs which are continuing to fall, and will likely not be negatively impacted by oil price changes. Supply chain issues resulting from the COVID-19 pandemic may cause some bottlenecks, but we expect these to be largely temporary. As battery chemistry improves and economies of scale build, EV prices should fall further.

We expect to see a tipping point in the mid-2020s as the production costs of EVs equalizes with that of combustion engine vehicles. At this point, sticker prices for EVs may fall further, making the TCO proposition for consumers even more attractive.

In our view, markets are underestimating the potential for a surge in EV production, even if global demand for combustion cars is hit hard by the current crisis. This EV tipping point is not yet fully priced in, which could create attractive investment opportunities in companies that are leaders across the EV value chain. However, those automakers who were slow to react to electrification, may prove increasingly uninvestable, as the increased demands on cash may prove too high a burden during the current production stoppages.


COVID-19 could change the mobility mix and accelerate the climate transition

The reliance on credit also changes the nature of consumption. Any change in the availability and cost of credit, or fears about recession, could have a strong negative knock-on effect on vehicle demand, and in particular on the vehicle mix. In previous recessions, the auto industry was hit hard as consumers delayed buying new vehicles, or switched to smaller vehicles (that typically emit less CO2). Similarly, other modes of long-distance and discretionary transport, in particular air travel, are closely linked to consumer confidence and react as discretionary goods.

We believe the COVID-19 pandemic could therefore have a more significant, dampening impact on demand for carbon-intensive transport than the boost to disposable income provided by the sharp decline in oil prices. It is also likely to change the mobility mix, and, in doing so, help accelerate the investment opportunity in lower-carbon and shared transport.


Investment opportunities continue to look attractive

At LO, we believe supply and demand dynamics across the transport sector have fundamentally changed, fueled by a powerful feedback loop of policy, consumer preferences and market forces. We expect the fall in the oil price and the impact of the COVID-19 epidemic will have a neutral or slightly positive effect on the speed and scale of the transition.

In our view, this backdrop continues to provide attractive investment opportunities in the transport sector. Our climate transition strategy aims to identify companies that provide solutions for shared and lower-carbon transportation, as well as those that are well positioned to gain competitive advantage as the Transport Revolution continues to unfold.


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