The traditional energy sector is under pressure as governments pledge to curb carbon emissions and institutional investors grow increasingly reluctant to provide financial support.
Yet paradoxically, oil and gas stocks — and ETFs and mutual funds that invest in them — have surged this year. For example, despite the recent plunge in oil prices, the iShares S&P/TSX Capped Energy Index ETF was up 76.3% in the year to date to Nov. 30.
Meanwhile, the three Canadian-listed clean energy ETFs that debuted this year have stumbled out of the gate. Shares of all three are down from their launch dates.
Uncertainty about what demand for oil will look like in a decade and beyond is deterring oil companies and governments from investing in new production, said Eric Nuttall, senior portfolio manager with Toronto-based Ninepoint Partners LP. “This is having an immediate impact on supply,” Nuttall told the Mindpath ETF conference in October, “and it’s one of the key reasons why the world is hurtling into an energy crisis.”
While oil demand is close to recovering from its severe pandemic-driven slump and will continue to grow, the Ninepoint Energy Fund manager said, supply isn’t keeping up.
Nuttall said the days of hyper-growth in U.S. shale-oil production are over, as these companies allocate more of their cash flows to dividends demanded by investors and less to exploration. Likewise, lack of new investment will result in OPEC running out of spare capacity by the fall of 2022, he predicted.
Thirdly, Nuttall said “super-major” multinationals like BP plc and Royal Dutch Shell plc are allowing oil production to fall in order to free up capital to invest in renewable sources. His conclusion: the surge in energy stocks is far from over. “I believe that the multi-year bull market for oil will last at least five or six years.”
Nuttall added that 40% of the demand for oil is for applications such as petrochemicals, plastics and rubber, which cannot be made without oil. Barring a global recession or depression, or a new vaccine-resistant strain of virus, “there are no short-term demand risks [for oil] that I can foresee.”
Late last month, one of those demand risks came into play. A new Covid-19 variant in South Africa sent the price of oil tumbling by about US$10 per barrel on Nov. 26 to US$68.15, the biggest decline since early in the pandemic as investors tried to price in another potential slowdown in the global economy. Shares of oil majors fell.
At US$70 oil, Nuttall said, the average Canadian oil company he follows could privatize by buying back all its shares and become debt-free, with only five to six years of free cash flow. “The market very clearly is ascribing zero value for resource reserves for cash flow beyond the next couple of years.”
The January contract for West Texas Intermediate closed at US$69.49 per barrel on Dec. 6.
Current valuations are more favourable for the conventional energy sector than for clean energy, said Karl Cheong, head of ETFs with Toronto-based FT Portfolios Canada Co., which operates as First Trust Canada.
Cheong cited recent forward price-earnings ratios of a relatively modest 15 times for the S&P 500 Energy index and 13 times for the S&P/TSX Energy index. By comparison, the S&P Global Clean Energy index was a much pricier 40 times.
The First Trust NASDAQ Clean Edge Green Energy ETF, launched in February on the Toronto Stock Exchange, has an even higher forward P/E of 60, Cheong said. The ETF’s largest single weighting was more than 40% in technology, followed by 24% in consumer cyclicals, including electric automakers. Unlike its U.S. affiliate, First Trust Canada doesn’t offer a conventional energy ETF.
“Renewable energy companies, green tech companies — they’re technology companies, meaning their future cash flows are further out,” Cheong said. As with other growth companies, shares of clean energy companies have been hit harder than value stocks this year by rising interest rates.
When comparing the performance of conventional energy to the multi-sector clean energy theme, Cheong said advisors and investors should look beyond the most recent trends. For instance, he said, in seven of the past eight calendar years, the clean energy industry has outperformed the energy and oil indexes in the U.S.
“There’s going to be compound annual growth rates in the green energy space that will far exceed [traditional] energy long term,” said Cheong. “The question as an investor interested in these sectors is which sector, longer term, would you place more of your money in? Our view is it’s clean energy and technology in that space that lowers the cost and makes it more efficient.”
ETFs with clean energy themes are generally invested in multiple sectors other than energy. For example, the Harvest Clean Energy ETF’s 40-stock portfolio is roughly half invested in utilities, so it’s largely a play on renewable power generation. Government incentives and decreasing costs are setting the stage for strong long-term growth, according to Harvest’s managers.
Power generation is an area “where it’s a lot easier to make the transition to renewables,” said Mike Dragosits, portfolio manager with Oakville, Ont.-based Harvest Portfolios Group Inc. “You have commitments from governments all around the world to make the transition.”
Clean energy initiatives on power generation and transportation include everything from decarbonization pledges agreed to at last month’s COP26 conference in Scotland, to billions of dollars in clean energy infrastructure spending and subsidies signed into law by U.S. President Joe Biden, to Prime Minister Justin Trudeau’s government escalating carbon levies.
While the world is shifting toward decarbonization, Ninepoint’s Nuttall said people don’t appreciate how long it’s going to take to transition to renewable fuels and electric vehicles for the 60% of oil demand that is transportation-related.
“There’s 1.3 to 1.4 billion cars that need to be displaced. That number is growing every year as the world’s population grows, as living standards grow. And yet total EV sales last year were five million.”
What’s often also overlooked, Nuttall said, is the source of inputs required for zero-emission solutions such as electric cars. In many countries, where electricity is generated by coal-fired plants, “it’s really a coal-fired electric car. Is that better?”
Complicating environmental, social and governance considerations are widely differing ESG methodologies, Dragosits said. Those that employ negative screening criteria exclude all fossil-fuel companies, while others rank these companies on a relative basis within their industry peer groups. “But from the bigger-picture perspective, you’re going to be focused on the clean energy side as opposed to traditional oil and gas.”
However, the two types of energy providers aren’t mutually exclusive. Cheong noted that giant energy companies are making substantial investments in renewable energy. “The business models are shifting. They’re trying to adapt to survive in a new environment.”