Yes, energy stocks are red hot. No, this does not constitute a great buying opportunity.
For anybody looking out more than a year or two, the oil patch is still a treacherous place. The industry continues to face headwinds that will nearly certainly intensify – a point emphasized this week by the International Energy Agency (IEA).
To be sure, the doubling in the price of West Texas Intermediate crude over the past year, and the 127-per-cent gain in the iShares S&P/TSX Capped Energy Index ETF, demonstrate that the world still runs on fossil fuels and will do so for many years to come. But soaring prices do not mean that the long-term fundamentals of the industry have suddenly shifted in favour of energy producers.
“There is no structural shortage in the global oil market, and any tightness could be resolved by [the Organization of Petroleum Exporting Countries] in a day,” said Gregor Macdonald, publisher of the widely followed Gregor Letter on energy transition, in a note this week.
The world consumed 99.7 million barrels per day (mbpd) in 2019. Consumption will recover to only 96.1 mpbd this year, according to the IEA, an intergovernmental agency that acts as a watchdog on energy issues for developed countries. Add the seven mbpd in OPEC spare capacity estimated by the U.S. Energy Information Administration and “it’s simply unsupportable to argue there is any actual shortage in global oil supply,” Mr. Macdonald wrote.
The trick for investors is to not get ahead of themselves. Demand for fossil fuels may no longer be growing, but flat fossil-fuel usage seems the most likely scenario over the next few years, according to Mr. Macdonald.
This steady-as-she-goes scenario will come as encouraging news for investors who are looking to cash in on the sector’s alluring dividends, but they should realize the risks involved. Many forecasters expect energy prices to subside over the year ahead as OPEC increases production and supply bottlenecks unclog.
Capital Economics, for instance, sees the price of Brent crude dwindling from around US$80 today to around US$60 a barrel by the end of 2022. Prices for both natural gas and coal are poised to take even bigger tumbles, according to the London-based forecaster.
The Calgary-based forecasters at Deloitte have a somewhat similar view. They see West Texas Intermediate crude averaging roughly US$66 a barrel in 2022 and falling below US$60 a barrel by 2024.
Headwinds grow stronger in subsequent years. Fossil fuel usage must decline in the decades ahead to keep climate change within acceptable limits, according to the World Energy Outlook published Wednesday by the IEA. The only question is how fast the decline will be.
In the energy agency’s most status quo scenario, which contemplates only the effect of climate policies already in place or already stated by governments, oil demand inches ahead to 104 mbpd by the mid-2030s, then declines slightly through 2050.
Under an alternative scenario, which assumes countries go ahead with their announced pledges on climate change, oil demand peaks at 97 mpbd in 2025 and declines to 77 mbpd in 2050.
Investors can debate which of these scenarios is more likely, but the direction of travel is clear. So is the effect of today’s high prices. Rather than being a long-term boon to the industry, they are likely to incentivize consumers and businesses to move faster on the transition from fossil fuels.
So what are investors to do? They can start by adjusting their expectations. Oil and gas producers are posting impressive results and many sport mouth-watering dividends, but they are no longer outstandingly cheap. The average company held by the iShares S&P/TSX Capped Energy Index ETF now trades for a hefty 23 times earnings.
Investors who like the sector may want to favour natural gas producers, since natural gas is the only fossil fuel with growth potential in the IEA scenarios, but even then they may want to hedge their exposure.
The natural way to do that is by investing in companies that will benefit from any transition away from fossil fuels. The list of potential beneficiaries includes electric-vehicle manufacturers, clean-energy producers, lithium miners, solar-panel makers, wind-turbine builders and others.
One of the simplest ways to get green exposure is by buying a fund that holds a diversified bundle of stocks in the sector. Among the many choices out there are CI Global Climate Leaders Fund, iShares Global Clean Energy ETF and Brookfield Renewable Partners.
Just don’t expect a smooth ride. As Mr. Macdonald notes, “this rather messy moment” in world energy is likely to continue for some time. Investors should make sure they are prepared for the bumps ahead.
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