By Lee Clements, Head of Sustainable Investment Solutions, SI Research
Energy and persistence conquer all things, said Benjamin Franklin, but is persistence in the energy markets the right thing for long-term investors?
The energy market has certainly had a very positive year so far. FTSE All World Oil, Gas & Coal is up 20% YTD (to end August), 39% ahead of the broader FTSE All World Equity Index. This is unsurprising given the 24% rise in Brent crude prices, the unprecedented impact to energy supply from the Ukraine war and an average 56% and 128% increase respectively in estimated revenues and EPS for the top 5 members of the index (2022 over 2021).
This comes on top of energy have been a significantly overlooked sector, underperforming FTSE All World for 8 of the previous 10 years. It has run counter to the performance of green economy stocks, as measured by the FTSE Environmental Opportunities All Share Index, which has outperformed the FTSE Global All Cap for 7 of the previous 10 years, but which is underperforming it year to date.
Looking more broadly across asset classes, whilst energy equities were strong (and less in utilities and basic materials), but energy bonds have not been so strong. Investment grade energy issuers lost 13.6% year to date, impacted by rising interest rates and 0.8% behind the WorldBIG investment grade corporate bond index (you would have gotten a better return from investment grade corporate green bonds). In high yield, the more natural place for small energy companies, energy bonds were 4.3% ahead of the FTSE High Yield Index, but still a -6.4% return. The highest investment returns have been made in commodities, most direct benefiting from the price increase as well as being an inflation hedge and arguably having less ESG aversion in owning oil futures than owning oil companies. Brent crude prices have considerably outperformed energy equities since the low of oil prices in April 2020 and year to date European gas has been the particularly outperformer, given the impact of shutting off Russian gas supplies on the market.
However, the performance of the energy sector year to date has not been backed by significant volume. Whilst natural resource funds saw inflows in Q1, they saw significant outflows in the last 3 months (and the strongest inflows were back in 2020). In addition, most large energy stocks and key energy futures have not seen significant increase in volumes.
Looking to the future, it is also difficult to see the strong positive future signals for the sector, estimated average revenue and EPS growth for the same top 5 energy companies are -10% & -12% for FY23 and -12% & -18% for FY24. The oil market is also in significant backwardation, with the front end of the curve for Brent (Dec 22) having gone up $20 YTD, but the longer end of the curve (Dec 25) only $4. You also haven’t seen a significant growth in the rig count in response to the raised oil prices, with the current count of 605 only up from 480 of 2021. This is well above the pandemic low of 180 (in July 2020) but still way below the 1,000 plus rigs last time WTI was above $95 (in the 2011-2015 period). This is beneficial to keeping oil prices high, but may indicate a lack of conviction in their long-term direction.
Short-term supply conditions and government plans are positive for energy markets, with European countries in particular trying to stimulate local production and search for non-Russian supply. However, there are also more concerted plans to boost alternative energy, such as RePowerEU and the US Climate Bill and decouple power markets from fossil fuels prices, which could weaken future demand growth and act as structural headwinds to the oil price.
This all leads to the tricky question of whether the energy market is more suited to short term commodity traders or long term asset allocators. Balancing geo-politics, energy security, sustainability/climate change issues and overall demand makes determining likely future returns challenging. Similarly, the current toxic triangle of inflation, rates and recession make determining correlation between energy and other assets classes (or determining correlation between any asset classes) challenging and some of traditional correlations, such as the negative relationship between the US dollar and oil prices, have weakened so far this year.
If only we’d remembered to charge our crystal ball!
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