By: Paul Baiocchi, CFA*, Chief ETF Strategist, SS&C ALPS Advisors
Energy is the best performing sector in 2022 and if that holds through the end of the year it will mark two consecutive years of energy sitting atop the sector periodic table. This recent outperformance has largely been driven by fairly short-term dynamics: Under-investment in new production coming out of the COVID crisis, geopolitical volatility, supply chain issues and fundamental improvements at the company level bearing free cash flow fruit. As a result, some advisors are wondering if they missed the energy story.
After all, entering 2022 energy was the worst performing sector six out of the last 10 years and has been the most volatile sector. Energy companies can only decrease leverage for so long, wars typically do not last forever, and supply chain issues should eventually ease. What’s more, energy—at least fossil fuels—have become a bad word in Washington while ESG strategies often exclude fossil fuel companies by rule. Why then would someone invest in an energy sector portfolio or overweight energy when the short term drivers of strong relative performance are likely to abate and the long term backdrop for energy companies as we know them is challenged by negative sentiment?
The reality is that the energy sector as we know it will look different next year than it does today and will continue to evolve over the next 30 years. In fact the word energy is typically associated with fossil fuels, but as we undergo a decades-long transition away from fossil fuels the definition of an energy company will change. Everything from natural gas to hydrogen to wind and solar will ultimately play big roles as will more obscure technologies; like geothermal and renewable fuels.
It is important to note that the investment in decarbonizing the planet will, based on some estimates, eclipse $150 trillion over the next 25 years and not all of that money will be spent on wind farms or solar panels. Much of that investment will go to carbon capture projects, hydrogen and fuel cell infrastructure, energy storage solutions (batteries) and even nuclear power. To that end, the investments by the private and public sectors in the energy transition will take many forms. There will be no single winner nor will there be one single “energy” source that the world runs on. It will also require the participation of fossil fuel companies whose cash flows and balance sheets are already being deployed in many of these segments. We will witness a wholesale repurposing of assets both physical and human toward renewable energy projects with a wide range of beneficiaries.
Pipelines currently moving natural gas or crude oil around the country will eventually move carbon dioxide, hydrogen or renewable fuels. Engineers focused on “dirty” energy projects will be deployed to solve renewable energy problems. Small-cap renewable energy firms will either be acquired by legacy energy companies or graduate into the large cap segment as their markets grow.
In the meantime, we will continue to rely heavily on natural gas to meet the increased demand for electricity as electric vehicle adoption grows. As storage costs decline and technology for higher latency energy sources like wind and solar improve, we will see greater adoption at scale. We will continue to need crude oil to fuel the millions of new internal combustion engines that hit the road every year in a market where the average age of a vehicle is the oldest it has ever been. All the while brilliant people will continue to develop and research alternatives to the status quo. Although nobody believes that the energy transition will happen overnight, many believe it will leave legacy energy companies out in the cold.
The truth, as always, in somewhere in between. With ambitious goals to increase electric vehicle adoption by 2035 and to get to net-zero by 2050, countries around the world will deploy an incredible amount of capital over the next 25 years. That capital will not be centered on one specific technology or one specific solution. A myriad of investments and solutions will define the energy transition and investors will need to rethink their energy allocations to participate.
The energy transition represents one of the most significant secular trends of this generation and the beneficiaries will be necessarily diverse. By forsaking fossil fuel companies investors risk missing out on the yield and free cash flow characteristics of a legacy energy portfolio which can, in years like 2023, offset the multiple compression of higher growth, lower profitability renewable energy strategies. By redefining your energy allocation as an energy transition carve-out that marries legacy energy companies with renewable energy companies and other related segments—lithium miners, carbon credits and hydrogen companies for example—you can build for the future while not ignoring the present or the in-between.