September 11, 2020

How the Changing Energy Picture Affects Investments

The differing trajectories for oil, gas, coal, and renewables pose a complex opportunity for investors. Here’s what you need to know.

Reported by Sarah Min

For some investors, it presented opportunity: the market swings in March owing to an oil price war between Saudi Arabia and Russia, as well as the continued volatility from a pandemic that has kept people from fueling up at the gas station.

The opportunity was to bet that stock prices would tank. Thus far this year, a fund to short carbon-related equity and credit from Massachusetts-based hedge fund HITE Hedge Asset Management (HITE) has soared about 25% through August. That’s nearly quadruple the roughly 7% the portfolio returned by the same time last year, according to investor letters seen by CIO. Investors in the HITE Carbon Offset Fund, a fund started two years ago from the $525 million firm, hold the view that significant reductions in fossil fuels in the world economy are inevitable.

These shorts are hardly devotees of green ideology. “We’re not tree huggers,” said James Jampel, co-CIO of HITE. “We’re just looking at this and saying, ‘Of all the places you can invest your money, why would you put your money in this place when there are so many things wrong with it?’”

Pessimism about oil, natural gas, and coal has been growing for a while. Even before this year’s market volatility, many investors had a dismal outlook for them. The legacy energy industries, which have long been constrained by overcapacity, now have to deal with the growing strength of environmental, social, and governance (ESG) investing.

In the past 12 months alone, many university endowments and pension funds have divested from thermal coal, oil sands, and other “dirty” fuels, including Georgetown, the University of California, and more than half the public universities in the United Kingdom.

Still, many institutional giants have not given up on traditional fossil fuels. Even as the Canada Pension Plan Investment Board (CPPIB) puts money into wind farm operators, it continues to invest in oil and natural gas, which it sees as attractive investments for many years.

“Things are certainly not as expensive as they were yesterday. That’s definitely the case,” fund CEO Mark Machin said in a March speech, according to news agency the Canadian Press. And the CIO of the California State Teachers’ Retirement System (CalSTRS), Chris Ailman, has also publicly said that he does not believe yet in fully divesting from fossil fuels.

HITE’s Jampel indicated that his firm also believes natural gas and oil are not going away soon. It’s just that their stocks will underperform the market going forward. “There probably is not going to be a lot of profit in the business,” he said.

So, what is the investment outlook for different sectors?

Not All Coal Is Created Equal

Once the predominant source of energy in the US, coal has dropped from its perch as the number one asset in the 1950s, and now is losing market share to natural gas. Coal assets have dropped to about 11% of energy consumption, down from about 36%, a trend that is expected to continue. The asset is a major target of ESG advocates and a number of institutions have declared they are ridding themselves of it. Notably, in 2016, Rio Tinto sold an Australian coal mine to local miner TerraCom for just one dollar.

Still, people are expected to continue to use coal in China, India, and other emerging markets, where the fuel is still a large component of energy sources. “It’s a cheap fuel and people want electricity,” said Andrew Gillick, managing director and energy sector strategist at energy research firm Enverus.

There are also some opportunities in metallurgical coal, which is required for steelmaking and is less likely than thermal coal to wind up an orphaned asset in the future. Metallurgical coal is used to release carbon molecules during the smelting process and combine with the iron ore to create “pig iron,” or the crude product that is used to produce steel.

Cleaner alternatives to produce steel exist, but they are far from ready technologically. Metal-oriented coal is expected to decline 17% by 2040, while thermal coal will tumble 65% over the same period, the International Energy Agency (IEA) forecasts.

Steelmaking during the pandemic is not doing too well, given that consumers are not buying as many products, such as refrigerators, toasters, or cars. But that downturn should end with the recession. It’s an industry that may fare better in the future with an expanding economy.

Has Oil Hit Its Peak?

Investor sentiment around oil is mixed. Long-term, plenty of investors are not sure whether it makes sense to invest in a commodity that might have hit its peak during the pandemic—or will in the not-too-distant future.

Still, some investors are believers in the sector, even if enormous patience is required. Matt Clark, investment chief at the South Dakota Retirement System, said the roughly $13 billion pension fund has overweight positions in energy, particularly in oil. Right now, prices are so low that producers aren’t bothering to build new extraction facilities, he wrote.

“The lags for oil production, particularly outside of shale, can be long so it may take several years for underinvestment to impact supply/demand balance sufficiently to impact pricing,” Clark wrote in an email. “We are long-term investors and willing to be patient.”

While electric cars such as Tesla or the Nissan Leaf are expected to gain market share in coming years, the more immediate risk to oil is the growing popularity of fuel-efficient cars, said Andrew Maday, senior vice president at Callan’s Private Equity Consulting group. Until the US develops a better infrastructure to fuel up electric vehicles, “there’s still going to be a role for oil or petroleum” over the next two decades, Maday said. “I don’t believe gasoline to be extinct overnight.”

Natural Gas, and the Emergence of Peaker Plants

Investors broadly agree that natural gas is likely to be the bridge fuel to the future, whether that’s new hydrocarbons or other renewables. That necessity is playing out now in California, where people are getting rolling blackouts, because there isn’t enough power delivered to the grid. The reason is that many fossil fuel plants have been retired, thanks to state regulations.

Some experts said there should always be some “peaker plants,” or natural gas plants that fire a couple days out of the year during times of high demand when millions of Californians lose access to power.

Still, Gillick says, the energy evolution from fossil fuels to renewables will take a long time. “We’re not going to transition away from hydrocarbons in my lifetime, that’s for sure. Will they eventually be in decline? Sure,” he said.

How to Bottle Sunshine and Wind

Thanks to tax incentives, solar and wind technology are more commercially viable and more popular with investors than they have ever been. Increasingly efficient solar cells are attracting more investors who have previously focused their attention on wind farms. But that has raised some red flags for analysts who worry that the sector is getting too competitive and that investors may not get the returns they were anticipating.

“There is continued growth in the segment, but you just have to be cautious with who you’re partnering with,” Callan’s Maday said.

Other storage and infrastructure issues remain. It’s hard to store energy generated from solar panels and wind farms. But some investors are starting to get proactive. “We’re starting to see more activity on the storage side, instead of just the generation side, which is critical for solar and wind,” Maday said.

Still, experts agree that the space is transforming. “It feels like we’re at a tipping point in the energy sector right now just in the way people are shifting investment strategies and thinking about the future,” Gillick said.

“The path forward, in my mind, globally is a combination of everything that we have right now,” he continued. “It’s not, you know, wind and solar replacing the oil and gas—it’s a combo of everything.”