How the Climate Crisis benefits Oil
Before I get into this week’s article, I would like to bring you an update. I have decided that alongside my weekly article, I will create a portfolio. I will add a security each week to this, based on the research I produce in my newsletter, and will review its’ performance periodically. This will help convey my conviction on each recommendation, and hopefully, show you how to construct a portfolio with good risk management. This will keep me accountable for every article I produce, as it has a real effect on the credibility of my newsletter (no pressure!). I feel there is a lot of investment research/columns posted to provide information not relevant to the current macro-environment. Therefore, I hope that every article I write will be posted considering the information and dangers currently facing markets, and I will allocate capital accordingly. Therefore, you will see my thought process in real-time and this should help your understanding also. I hope this makes the articles more exciting and interactive. Please leave any feedback/questions in the form on the home page.
There’s a reason it’s called ‘Black Gold’
Taking a step back from the commotion around Climate Change and the craze of ESG/Renewable energy investing, we can see that the world is still highly dependant upon Oil. Despite the insistence of environmental groups and governments that we must change our energy consumption habits, and the sources we obtain energy from, Oil is still essential to daily life and will be for some time.
The US is currently the largest consumer (and producer) of oil in the world, using 19.6 million barrels per day (mbpd). Looking at the line graph below (omitting 2020 data for obvious reasons), Oil demand is relatively inelastic i.e. changing prices do not affect demand. Therefore, supply is the dominant factor in the price of oil - and the subsequent performance of Oil stocks.
Oil Demand is unrelated to the Oil Price, Source: Bloomberg
Previous bull markets for oil were centred around infrastructure spending. Looking back to the early 2000s, prior to the Great Financial Crisis of 2008, huge infrastructure spending through housing resulted in a $100 p/b oil price. Recently, there has been a lot of noise in both the news and financial markets regarding US President Joe Biden’s recent stimulus package. Regardless of the final number passed through congress, it’s huge and incorporates several aspects to fight climate change. It includes building electric power lines that can deliver more renewable energy, building electric vehicle charging stations, capping oil and gas wells to reduce emissions, and reclaiming abandoned coal mines. There is money to build a million new affordable, energy-efficient housing units and to make existing structures more energy efficient. Biden also aims to increase how much energy the US obtains through renewable sources (wind turbines, solar panels, etc). Sounds bullish for renewables, right? Let’s take a closer look.
“Installing one Wind Turbine uses 18,857 barrels of fuel”
According to Forbes, installing the foundation of a single offshore turbine can consume 18,857 barrels of marine fuel during construction. Offshore wind farms often have over 100 turbines, meaning that construction requires almost two million barrels of fuel just to power the ships involved. Furthermore, the indirect use of oil in producing and transporting parts, along with the maintenance and upgrading of the turbines (as aviation, shipping, and lorries all rely on it), means the use of oil is huge. There is a similar outcome in the construction of many other Renewable energy projects.
Alongside this, investment in new oil wells is being capped, reduced, or halted. Last week, Royal Dutch Shell (LSE: RDSA) agreed to sell its business in the Permian Basin to ConocoPhillips. This is the largest oilfield in the United States, and one of the reasons for the deal is the mounting pressuring on the company to move away from fossil fuels. Although this oilfield has only been transferred to another producer, it is an example of the pressure currently on oil companies to divest. The International Energy Agency (IEA) has stated that to reach our goals of net zero emissions by 2050, exploration and development of new oil and gas fields must stop this year. They are calling for the end of oil. If the world were to listen to the IEA, energy prices would soar, and a monumental recession would occur.
As I said, supply is the main factor affecting the oil price. A falling supply has the potential to create a market mismatch and price surge. With renewables and huge infrastructure projects (Smart cities etc) being encouraged, demand is there, and I believe this could create a long-term bull market for oil. A $100 p/b oil price is not far away.
Get it while it’s cheap
As COVID hit the western world, oil companies were the worst affected due to lockdowns. Once the vaccine news broke in early November there was a huge momentum crash and we saw airliners, oil stocks, and other cyclical’s rise up to 30% in a day. Some have continued to rise into the new year along with the oil price, while others have stalled (e.g., Royal Dutch Shell). Some of the underperformance has been due to the rise of ESG Investing which led to many funds dropping energy stocks from their portfolios. Oil stocks are now unloved but are still essential to daily life, and the big climate change push, as you see above. This creates a contrarian opportunity to buy into the development of a more sustainable world at bargain-basement prices.
I like Renewables as much as the next guy. But the issue I have with many Renewable energy stocks today is they trade at a premium to net asset value (for funds) or at extremely high valuations. Yes, you may be paying up for higher growth, but the current environment of tightening liquidity and higher inflation does not bode well for such companies. Liquidity (cash) drives markets. Tightening liquidity over the next 12 months is set to bring valuations down. A back-of-the-envelope way to calculating excess liquidity is the percentage change in M2 Money stock (cash, bank deposits, etc) minus the percentage change in nominal GDP growth. As you can see below, it is falling rapidly.
Change in M2 Money minus Change in GDP growth (YoY), Source: Bloomberg
There are several reasons, aside from ESG-related, for the negativity toward oil companies. Many of the supermajors cut or stopped paying dividends last year as oil prices crashed, causing many investors to look elsewhere for income. However, many have now reinstated dividends or given forward guidance on when they will do so.
Also, the recent surge in the Delta variant has also created fear in the market of further reduced demand. This is no longer a worry (Discussed in last week’s column).
There is a risk that the slowing growth in China (second-largest oil consumer globally), and a potential collapse of China’s biggest Property Developer, Evergrande, could lead to a pop in the Chinese Property market. However, I believe China will bail out Evergrande. This is further confirmed with the latest banning of cryptocurrencies. The last thing the CCP wants is their citizens exacerbating the depreciation of the local currency further, so they will be left holding the bag.
This week’s column is another form of the value play I spoke about last week. There are several ways I could profit from the bull market in ‘Black Gold’. iShare’s S&P Commodity Producers Oil & Gas ETF (SPOG) gives direct exposure to producers in the US, Canada, and Russia. This ETF, like many oil stocks at present, looks set for a breakout of its recent highs (see below)
Safer companies are supermajors like Royal Dutch Shell (RDSA) and BP PLC (BP) provide stable exposure with a dividend - and some exposure to renewables in the future no doubt. Finally, more speculative investments you could do further research on are explorers and off-shore drillers such as Transocean (RIG) or 88 Energy ltd. These are high-risk, high-reward opportunities and so correct position sizing is very important. Transocean, in particular, may benefit as US President Biden attempts to move all oil drilling off-shore.
SPOG looks set for a breakout over 1200p, Source: Bloomberg
How to Actively Invest
Like many industries, the financial markets are full of jargon which makes investing and finance seem hard to understand. However, many of the concepts are relatively simple when conveyed in layman’s terms. At the bottom of each newsletter I post, I will explain one of these for you, to help make things a little easier for everyone starting out.
Active Investing involves constructing a portfolio of assets that you hope will beat the market’s return over time. Many of the greatest investors in the world, such as Warren Buffet and Stanley Druckenmiller have consistently done so for decades, which is why their names are in the history books. But should you Actively Invest?
The first thing you must consider if you want to actively invest is time. Do you have the time to analyse market conditions and research sectors, industries, and individual stocks to exploit inefficiencies within the stock market? This requires huge amounts of time, effort, and skill. It will take years to successfully beat the market (and some may never achieve it).
If the answer is no, invest in an index tracker. An index tracker is a low-cost security that tracks the performance of, for example, the 500 biggest stocks in the US – this is called the S&P500. Over the past 121 years, since this index was created, it has returned an average of around 10% per year if you include dividends. This is substantially more than the current interest rates in your savings account. If through active investment, you cannot beat this return, then there is no point in spending the money on fees, and time and effort finding companies. Just buy the index. There is no shame in this. As the paragraph below will show.
Here is a scenario. You start with a balance of £1000 in your investment account. You use that money to buy £1000 worth of S&P 500 Index shares, and then consistently buy £200 per month of S&P500 shares for 40 years (average working lifetime). You will retire with £1.16 million. Of course, this does not come without hiccups along the way. One year (E.g. This year) you may be up 20%, and another year (e.g. March 2020) you may be down as much as 32%. But if you continue to buy no matter the price, your will average in at a great price and finish with the above amount. For any new investor, whether you aspire to actively invest or not, I recommend you start with an index tracker, and once you develop enough experience and knowledge, then you can start actively investing.
I hope you have enjoyed this edition of The Spark. Please leave any questions or comments you may have as I would love to hear your feedback!
Until next time.
Peter
Disclaimer
This communication is for informational and educational purposes only and should not be taken nor used as investment advice, as a personal recommendation, or solicitation to buy or sell any financial instrument. This material has been prepared without considering any particular recipient’s investment objectives or financial situation and has not been prepared in accordance with the legal and regulatory requirements to promote independent research. Any references to past or future performance of a financial instrument, index or structured product are not, and should not be taken as, a reliable indicator of future performance. I assume no liability as to the accuracy or completeness of the content of this publication.