This week, I examine the whys and wherefores of investing in one of the market’s largest and most diverse sectors: energy. Investors have numerous ways in, with dozens of stocks across the broad range of energy sub-sectors. There are many options in the UK, but more in overseas markets.
These options range from global megastocks to start-up minnows, from ‘dirty’ to ‘clean’ energy, old technology to revolutionary, from ‘upstream’ to ‘downstream’, and from production-focused to consumer-focused. The different types of focus and business models attract vastly different equity valuations, from bond proxies with more stable and predictable returns to the volatile ‘hockey stick’ growth (or declines) of start-ups and ground-breaking technologies. You can invest in businesses that only attract low single-digit price/earnings (PE) ratios through to aggressive discounted cash flow (DCF) valuations on businesses that are still a long way from even breaking even.
There is a twin-track opportunity at present in the energy sector:
1) Ballooning profits due to high energy prices stemming from global shortages – although these come with the risk of windfall taxation by governments and subsequent de-rating by markets. Not only do excess taxes cut earnings directly, but they can also be seen as having a ‘PE of 1’ as the boosted profits are temporary, volatile and an ‘unearned’ income source, not flowing from anything strategic. Profits can be bolstered for longer if something constructive is done with the extra cash flow other than buybacks and special dividends – investing in clean or green energy, for example – but typically this does not happen. In this cycle, the boost to profits for the ‘old’ or dirty energy businesses has been so strong that returns are high enough to withstand even sharp de-ratings.
2) The global drive to decarbonise means huge flows of funds into newer and more dynamic energy sub-sectors, with big swings already visible in the world’s energy generation profiles. While the point above is likely to prove transitory, the move away from fossil fuels is a trend set to move at pace for at least 30 to 50 years.
Commodities: oil and gas et al
This is by far the largest, and in the UK FTSE listings there are more than 100 companies with market valuations from £172bn right down to below £1mn.
The largest businesses are generally the integrated oil and gas producers such as Shell (SHEL) and BP (BP.), which offer diversity through exploration, extraction, refined products (fuels, lubricants etc), petrochemicals and retail, plus fledgling (but largely underinvested) green and alternative energy operations. These have been steady-returning stocks for investors over many years, even decades, with these two UK giants each offering a total annual return over 30 years of9 per cent. It is easy to see that old-financial market wisdom such as ‘never sell Shell’ certainly rings true. For riskier investments, investors could (prior to this year) look to the likes of UK-listed Russian producers such as Rosneft (ROSN) in global depositary receipt (GDR) form or, to play the bigger game, look to the US where leaders such as ExxonMobil (US:XOM) and Chevron (US:CVX) have comfortably exceeded the long-term returns of the large UK players.
At a smaller scale come the exploration and production (E&P) companies, which are generally involved in searching for and proving reserves of oil and gas, with the deposit typically then sold to an integrated business. These are somewhat akin to biotechnology businesses in the pharmaceuticals sector, with many hoping to hit the jackpot and find substantial new deposits. This makes E&P share prices more volatile as prospects fail or come up dry more often than they exceed expectations. Investment here can be a rollercoaster. Tullow Oil (TLW), for example, had a 40p share price in 2000, rising to 1,250p in 2012, then 7.5p in 2020 and back to 40p today.
Taking a tangential step, one can invest in industry consultants – in the UK this is largely limited to the indebted John Wood Group (WG.) or infrastructure and equipment businesses such as Hunting (HTG) – but these can prove very cyclical.
Coal used to be the dominant form of energy in the UK, but the industry has largely died out here. What little remains is largely in private hands, so anyone wishing to invest in coal needs to look to the US and the likes of Peabody (US:BTU) or Australia’s BHP (BHP).
An interesting thing about oil and gas is that despite the world looking to decarbonise, demand for oil and gas is forecast to keep rising until 2030 (for gas) and 2035 (for oil). Growth will slow as oil’s largest end product, automotive fuel, gives way to electric cars. But some nations (for example India) are not aiming for zero carbon until 2070, while China is dragging its feet and the US is finding it hard to end its love of gasoline. For natural gas, there is a similar long tail in power generation and domestic use, plus the largest use of natural gas s the production of ammonia to make fertiliser, where few alternatives are emerging. However ‘dirty’ this end of the sector may be, the outlook feels robust.
Change in global oil demand to 2035
Source: Opec
Consumers: power generation & distribution
Where most of us connect with the energy industry is through our domestic supply, and in this space in the UK is a small number of network operators, generators and power utility businesses. These businesses typically have predictable profits and cash flows, and benefit from often tight regulation that keeps things stable. The biggest option in the UK is network operator National Grid (NG.), a largely energy-price-agnostic business and one and with the share price performance of a bond proxy: slow and steady. In UK generation, investors can opt for a blend of traditional and renewable generation via SSE (SSE) or the more contentious wood-burning power generation of Drax (DRAX). To invest in nuclear, investors have to look overseas. EDF (FR:EDF) in France owns the UK nuclear network, or another option is to invest in uranium stocks such as NexGen Energy (CA:NZE) or look again at large miners such as BHP.
The US offers greater choice in the power utilities sector, with an array of more plodding businesses right through to rapidly expanding companies with steeply rising share prices, such as NextEra (US:NEE).
Investors could also look at batteries, which come in formats for electric vehicles, houses, factories, district systems and network/grid batteries. These help smooth power delivery and balance generation and demand, especially from the likes of wind. Here one might encounter the volatile Tesla (US:TSLA), German utility RWE (DE:RWE) and the UK’s Smart Metering Systems (SMS), better known (as the name suggests) for smart meters.
The changing face of UK electricity generation (terawatt hours per year)
Source: UK National Statistics | * = Solar, hydro and all other fuels
Newbies: revolutionary tech
When we think of next-generation fuels, we primarily look at hydrogen and fuel cells, although there is nothing really new here: hydrogen fuel cells were invented in 1842. But hydrogen is becoming a larger part of the global energy mix via increasingly largescale fuel cell usage. This is mainly for small, local micro-generation rather than grid level, with perhaps the greatest potential being in heavy electric vehicles such as buses and lorries, where batteries do not really work at the moment. Development of its use in passenger cars is proving difficult as batteries are pre-eminent as replacements for petrol and diesel. Hydrogen can also be used as a full or partial replacement for natural gas in heating or thermal power stations, while ‘green’ hydrogen, using reversed fuel cells and renewable power, could replace the dirty ‘grey’ or methane reforming process that currently makes almost all of the world’s hydrogen.
For investors, progress seems to be very stop-start, and share prices are volatile – see the recent two-thirds drop at ITM Power (ITM). The US really has the best offering for investors here through the likes of Plug Power (US:PLUG) or Bloom (US:BE).
Potentially the greatest source of cheap, clean new energy is nuclear fusion. There are some 35 fusion businesses globally, currently all privately owned, but these are likely to come to public markets as private equity money is flowing in. Private equity will be looking for time horizons of five to 10 years to exit, so this is something to track into the 2030s – assuming the technology can be proven to work.
Greens: renewables
This has to be the highest profile area of greener and cleaner energy. Today in the UK, 39 per cent of electricity generation is from renewables (mainly offshore wind), and it is fast catching up with fossil fuels (almost all gas) at 42 per cent; nuclear accounts for the remainder. Here the focus is on energy captured directly from nature’s energy sources: wind (onshore and offshore wind farms), solar (photovoltaic), solar thermal (turbines using steam produced by sunlight), hydroelectric generation (dams and pumped storage), biomass (methane from rotting foodstuff to burn), biofuels (liquid fuels refined from foodstuffs mainly for vehicles), tidal energy, geothermal (heating from below the earth’s surface – at grid level and micro through domestic ground source heat pumps), wood pellets (a contentious area with net carbon footprints) and ‘second life carbon’ synthetic fuels (made using CO2 extracted from the atmosphere and renewable electricity).
There are surprisingly few ways to invest directly in renewable energy in the UK, and a composite approach may be needed, such as investing in SSE. The largest wind operators in the UK are Denmark’s Orsted (DK:ORSTED) and Norway’s Equinor (NO:EQNR). For a pure play, investors could look at Greencoat UK Wind (UKW), an investment trust.
Solar is small with a lot of private and community ownership plus micro-generation through domestic solar panels, although there are investment trusts in this space, too. Hydro is limited in the UK and investors would need to look to China, Brasil, Canada or again EDF in France. Geothermal too is tiny in the UK (0.3 per cent), but is more material in the US although again few investment opportunities exist. The best option is perhaps Ormat (US:ORA). In the UK, biomass is the second-largest generating source after wind, but has long prompted questions over how renewable it really is (given it is mostly burning wood pellets). Drax is dominant in this space.
Next steps
The landscape for investment in energy is large and sprawling. To help to navigate a clearer path, I will be writing a series of three more in-depth articles where we will look more closely at three markets: 1) old and dirty energy; 2) renewables and new energy; 3) generators and utilities.
