The energy crisis could turn energy stocks into a secular winner
Head of Equity Strategy
Summary: Equities ended 2021 with a gain of 23.3 percent in USD terms in the MSCI World Index, extending the 14.3 percent gain in 2020. While these returns are much higher than the long run returns in equities, the MSCI World is still below its long-term trend since early 1970 and the US equity risk premium is currently estimated at 4.7 percent. If we add the current US 10-year yield then the expected return is 6.4 percent in US equities. While we do not think the overall equity market is overvalued relative to interest rates, there are definitely speculative pockets of the equity market that exhibit bubble-like tendencies. These pockets have declined sharply over the past three months due to rising interest rate expectations.
Last year, a global energy crisis emerged slowly before exploding in the hands of Asia and Europe in the latter part of the year, with European natural gas futures soaring 2,381 percent since May 2020. Higher energy prices—the main theme of this quarterly outlook—are a tax on consumers and businesses. They can push up consumer prices and shrink margins through higher direct operating expenses and secondary inflationary pressures hitting industries differently. They can also push interest rates higher, directly lifting the discount rate on future free cash flows and thus lowering equity valuations. There are many reasons to believe energy prices will remain elevated for the foreseeable future due to underinvestment, ESG and the green transformation enticing investors to get exposure to the overall energy sector to balance their portfolio against an overweight in technology and growth stocks.
Energy sector has diminished to an insignificant role in equity markets
In January 1995, the energy sector had a 10 percent weight in the S&P 500 and was thus the fifth largest sector by market capitalisation in the world’s largest economy and equity market. From this onset the energy sector experienced an incredible boom period, peaking in June 2008 when the Brent crude price hit $140/barrel. During this period the global energy sector outperformed the global equity market by 7.5 percent annualised, delivering a total USD return of 16.2 percent annualised.
The biggest underlying force behind the energy boom was China’s rapid economic progress and—most importantly—adoption into the WTO, unleashing an unprecedented offshoring of production in the OECD countries to China. The Chinese economy was less energy-efficient than the industrial sector in the OECD countries and the majority of electricity generation for households and industries came from coal, oil and gas. The galloping energy prices from 1995 to 2008 led to an investment boom that would later come back to haunt the sector. But by June 2008, the energy sector had increased its S&P 500 index weight to 16.2 percent, only surpassed by the information technology sector at 16.4 percent and even surpassing the financial sector at 14.2 percent.
The exuberant month of June 2008 was the summit for global energy as the world plunged into a devastating credit and subsequent economic crisis. Despite massive stimulus from China and the US pulling the entire world out of the abyss and a subsequent rally in energy prices and energy stocks, long-lasting damage was underway. Massive overinvestment in oil and gas exploration coupled with significantly higher cost levels in the sector that were shaped during the boom years caused profitability and return on capital to go down. Demand was also not growing at the same rate as before as China’s urbanisation was maturing and its economy was getting more energy-efficient, while the global economy was suffering from the effects of the financial crisis.
From June 2008 to December 2021 the global energy sector underperformed the global equity market by 9.4 percent annualised, giving upits previous 13 years of outperformance and more. The global energy sector declined 21.2 percent during the period from June 2008 to December 2021—the nominal return before subtracting inflation. The global equity market rose in the same period by 201 percent, and as of December 2021 the S&P 500 index weight of the energy sector had plunged to 2.7 percent, making it the third smallest sector and barely surpassing the materials and utilities sectors. Meanwhile the information technology sector had increased its S&P 500 index weight to 29.2 percent.
The hard truth in 2022 is that the energy sector plays a minor role in global equity markets in terms of impact on returns, but our entire global economy is still run on energy. Our rise in wealth over the past 300 years has been one long technological journey from burning woods to burning coal before discovering oil and gas, and next venturing into nuclear power, before transitioning into renewable energy sources such as wind and solar. Because the world runs on energy it is hugely important for the economy and the energy crisis is telling politicians, consumers and businesses exactly how important it is and how we have all been taking it for granted.
Starvation of investments in the physical world
There are many reasons behind the current energy crisis—some short-term and others long-term. Some of the most obvious are China’s U-turn on coal power, Germany abandoning nuclear power, Russia’s geopolitical play, a global natural gas market through LNG, underinvestment in the supply of oil and gas, and extraordinary weather patterns reducing electricity production from hydro and wind turbines.
One of the most fascinating charts on the global energy sector is the change in capital expenditures from 2000 to 2021. The boom years from 2000 to 2008 led to a 350 percent increase in capital expenditures. The financial crisis only led to a small drop before investments began accelerating again, as the sector was confident demand would continue at the same pace. However, a miracle in oil fracking technology unleashed unprecedented oil supply from the US, causing prices to tumble and destroying the vast majority of investments made in the years 2009 to 2014.
Since the oil price plunge of 2014 to 2016 and subsequently, climate change awareness, coupled with ESG mandates and huge returns in stocks with exposure to digitalisation, have starved the energy sector of investments. The current level of capital expenditures is the lowest in 20 years in real terms and the lowest since 2004 in nominal terms. The investment drought that has lasted for more than seven years will set the stage for very attractive energy prices in the years to come. The biggest consumer of oil is the transportation sector, and as it moves to an electric future,the oil market is likely to be the biggest long-term loser from the green transformation.
But before we get there, the sector will experience another very profitable period during the energy crisis years. The global energy sector is currently valued at a 12-month forward dividend yield of 5 percent, and with a long-term dividend growth rate of 4.7 percent, the long-term expected return from investing the global energy sector is close to 10 percent. We think this could turn energy stocks into a secular winner over the coming decade and the implied expected returns are too good to ignore for global investors.
The energy landscape and its components in equity markets
Offshoring industrial production to China over the past two decades and politicians’ procrastination on climate change, accidentally coinciding with the digitalisation, have led to a dangerous inflection point where these “energy loans” will have to be paid back. The cost will be higher energy prices for a substantial period due to the green transformation, and significantly higher oil and gas prices due to underinvestment and the revelation that we must sin a little with fossil fuel energy to live in the “green paradise” in the future.
The table below shows 40 names in the global energy landscape across key industries such as coal, integrated oil & gas and exploration, solar, wind, hydro, nuclear power, hydrogen & fuel cells, and batteries. providing ideas for investors to get exposure to different parts of the energy landscape. We have excluded utilities as a separate category—although this sector is responsible for electricity production—as they are typically under strict regulation and cannot increase margins, and in some cases cannot pass on the full rise in input costs.
|Price-to-target (%)||5Y return (%)|
|China Shenhua Energy||Coal||67,078||9.4||101.2|
|China Coal Energy||Coal||12,120||16.6||46.8|
|Exxon Mobil||Integrated oil & gas, exploration||291,608||4.4||3.1|
|Chevron||Integrated oil & gas, exploration||241,019||4.9||34.8|
|Royal Dutch Shell||Integrated oil & gas, exploration||182,334||19.5||13.1|
|PetroChina||Integrated oil & gas, exploration||144,716||25.8||-23.6|
|ConocoPhillips||Integrated oil & gas, exploration||106,360||14.4||80.4|
|Gazprom||Integrated oil & gas, exploration||110,168||32.7||143.8|
|Schlumberger||Oil & gas services||49,134||13.3||-51.6|
|Baker Hughes||Oil & gas services||27,113||14.2||-30.1|
|Halliburton||Oil & gas services||23,291||16.1||-48.4|
|China Oilfield Services||Oil & gas services||8,540||33.8||1.0|
|LONGi Green Energy||Solar||67,686||40.5||1,449.6|
|Atlantica Sustainable Infrastructure||Solar||3,805||24.4||130.9|
|Vestas Wind Systems||Wind||28,494||22.5||122.4|
|China Yangtze Power||Hydro||79,925||16.1||133.2|
|Brookfield Renewable Partners||Hydro||16,050||24.6||178.5|
|China National Nuclear Power||Nuclear||20,289||9.0||25.5|
|Plug Power||Hydrogen & fuel cells||14,386||96.6||1,881.0|
|Bloom Energy||Hydrogen & fuel cells||3,378||76.8||NA|
|NEL||Hydrogen & fuel cells||2,337||22.1||565.0|
|ITM Power||Hydrogen & fuel cells||3,013||69.0||1,714.5|
|Panasonic||Battery & energy storage||27,908||25.0||22.2|
|Ganfeng Lithium||Battery & energy storage||27,557||69.6||NA|
|Albemarle||Battery & energy storage||27,609||12.6||171.5|
|Alfen Beheer||Battery & energy storage||1,948||4.3||NA|
Source: Bloomberg and Saxo Group
Quarterly Outlook Q2 2022
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