Over most of the last 60 years, oil company holdings were considered a core part of every diversified equity portfolio. While economically sensitive, the general upward trend in global energy consumption meant investors could count on earnings growth to support higher share prices and a steady flow of above average dividends over time. Savvy investors learned too to take advantage of the shares’ volatility – loading up on them when the economy and oil prices weakened and trimming back during their respective recoveries.
Energy shares’ cyclical nature have been on full display during the latest downturn. The Vanguard Energy ETF is the worst performer among the firm’s 11 sector funds, down 46% since the beginning of the year. Normally value-conscious investors would view this profound underperformance as a buying opportunity. Several secular forces, however, now caution against doubling down on traditional energy exposure.
A Prolonged Supply Imbalance: Oil and gas shares’ latest bout of underperformance began back in 2014 when new fracking technology unleashed millions of barrels of U.S. oil onto world energy markets. To understand the magnitude of this development, consider that back in 2008, the U.S. was still the world’s largest oil importer. Just 10 years later, it had become the world’s largest producer with an average of 17.9 million barrels a day or 18% of the world’s total. The resulting supply glut and collapse in energy prices forced many domestic producers to retrench and take existing supply off the market. The sheer size of these reserves, their low production costs and easy access is likely to contribute to a global energy supply imbalance going forward.
Cost Competitive Sources of Renewable Energy: Years of subsidies and investment in technology have helped make solar and wind cost competitive with more traditional fossil fuel alternatives. Solar PV module prices have fallen around 90% since 2009 while wind turbine prices are down 55%-60% since 2010. The world still relies on fossil fuel to supply 84% of its energy needs. But this year, 76% of new generating capacity in the U.S. will come from utility-scale solar and wind power installations (see chart below). While important road blocks still exist – further investment in distribution capacity and better battery technology are most needed – – we seemed to have reached a tipping point supporting wider renewable energy adoption.
An Adverse Regulatory Environment: Improved economics together with a growing chorus of environmental concerns are leading to stronger regulations supporting renewable energy. Thirty states now require utilities to buy a portion of their power from renewable sources and in 18 states, consumers can opt to pay above market rates to require their utility to buy “green” power. Recent weather events across the globe will likely further calls for energy market reform.
The debate over energy’s future is best witnessed by examining the strategies of some of its biggest players. BP and Total, two of the world’s largest integrated oil companies, have committed themselves to a carbon-free future. Their strategies include divesting billions of dollars of carbon assets while investing in renewable resources and technologies. Others, like Exxon Mobil, remain committed to a future tied to oil and gas consumption.
In a recent Wall Street Journal article, Daniel Yergin reminds us that it took two centuries for coal to replace wood as a primary source of fuel and another 100 years for oil to replace coal. Shifting away from fossil fuels will require more time, money and technology than many expect. Over the next few years, oil company shares will recover as the economy gains steam. But longer term secular forces at work across the globe mean that firms that have bet their future on fossil fuels will no longer have the wind at their back.