Would you rather bet on oil rigs or solar panels? Investors tend to be fervently committed to one sector or the other, often for reasons of ideology more than economics.
In fact, it makes a lot of sense to hold both. The two battling industries can offset each other’s risks.
To see how this works, start with the clean-energy sector – solar-panel producers, wind-power generators and the like. It has been highly volatile, but has outpaced the oil patch by a considerable margin over the past five years.
The iShares Global Clean Energy Exchange Traded Fund (ETF), composed of companies associated with renewable sources of power, generated a 21-per-cent annual average return between 2017 and today.
In comparison, the big fossil-fuel producers represented in the iShares Global Energy ETF produced only an 8-per-cent average annual return over the same period.
Over the past year, however, the picture has flipped. Oil and gas stocks have become the brightest spots in a dismal stock market, both in Canada and elsewhere.
A lucky investor who bought into an index of global energy producers in January would now be sitting on a 37-per-cent return. In comparison, someone who bought the iShares Global Clean Energy ETF would have lost 3 per cent.
The abrupt turnaround demonstrates the case for diversifying your bets on the world’s energy future.
Long-term trends are still all in favour of renewable energy. In a report this week, the International Energy Agency (IEA) said the global energy crisis sparked by Russia’s invasion of Ukraine in February has “triggered unprecedented momentum” for renewable sources of energy, such as solar and wind.
In what the IEA called its “largest ever upward revision,” the agency forecast that global renewable energy capacity will surge by 2,400 gigawatts over the next five years – “an amount equal to the entire power capacity of China today.” It also declared that renewables will overtake coal as the world’s largest source of electricity generation by 2025.
However, it’s important to put these trends into perspective. Coal, oil and natural gas accounted for 80.9 per cent of the world’s total energy supply in 2019, according to IEA data.
For all its enthusiasm about renewables, the IEA still expects global demand for oil to keep expanding until some time in the mid-2020s to the mid-2030s. It also expects the world’s consumption of natural gas to “keep growing strongly” for some years to come in all the scenarios it envisions.
Given these conflicting trends, investors may want to stop seeing energy investing as an either/or, winner-take-all situation. It’s quite likely that both clean-energy innovators and fossil-fuel dinosaurs will produce strong returns over the next few years.
In fact, the interplay between the two sectors could work out to the benefit of shareholders in both areas.
Think of it this way: So long as countries worry about their vulnerability to sudden swerves in oil and gas supply, the incentive to move to renewable sources of power will remain high, meaning ample expansion opportunities for solar and wind companies.
But if renewables expand as quickly as the IEA envisions, oil and gas producers will have little incentive to grow their output. That means supplies of oil and gas will likely remain tight and prices robust. It also means existing producers will be able to focus on returning profits to shareholders in the form of high dividends and share buybacks, as ExxonMobil and others are already doing.
What could go wrong for investors in this scenario? The biggest risk is that oil and gas prices might tumble, hurting the bottom lines of fossil-fuel producers while also reducing the incentive to move to renewables.
This could happen in the short term. Oil prices have already given up all of their gains since the Ukraine invasion and are now trading slightly below where they started the year. West Texas Intermediate, a benchmark North American grade of crude oil, was selling Friday for around US$70 a barrel, about US$50 a barrel cheaper than it was this summer.
The decline seems unlikely to be permanent, however. Falling crude prices reflect a new agreement among Western countries to impose a US$60-per-barrel price cap on Russia’s seaborne crude-oil exports. They also reflect a sombre outlook for the global economy next year, based on the belief that central banks are willing to risk recession to bring inflation to heel.
Looking further out, oil prices seem likely to recover once the global economy is back on its feet. Chinese consumption on its own could boost global demand substantially once Beijing fully reopens its economy from COVID lockdowns. Analysts at Capital Economics see prices for Brent, the benchmark European crude, falling in the first quarter of next year to around US$70 a barrel but then rebounding to around US$85 a barrel by the end of the year.
If that forecast is correct, oil companies should be able to generate solid profits and continuing streams of generous dividends. But if the IEA is right, clean-energy companies are on the brink of a historic expansion. Owning both seems like a fine idea.
Ian McGugan