Is now the time to invest in the energy sector?
You don’t have to be an avid market-watcher to realize that the energy sector is having a moment. Conflict in the Middle East is raising the price of oil. The insatiable thirst of AI-hyperscalers for electricity is helping out natural gas producers. Restarts of nuclear power plants in Germany and Japan are boosting demand for uranium. And, as reducing CO2 emissions becomes a more important priority for governments around the world, the future of wind, solar, hydroelectric and other forms of renewable energy seems brighter than ever.
For those on the hunt for intriguing investment opportunities, all of this is welcome news. Despite all of the attention which the stock market has heaped upon anything even remotely connected to artificial intelligence over the past several months, there’s a lot to like about the energy sector: inflation protection; reliable cash flows; juicy dividends; real asset security; the opportunity to get in on the ground floor of world-changing technology and more.
All of which is to say that it’s time to take a closer look at the energy sector, review the ins and outs of investing in it and understand what role it can play in a well-diversified portfolio.
Why energy: how an allocation to energy can help your portfolio
With exciting developments in semiconductors, artificial intelligence, cryptocurrency, private equity, critical minerals, cybersecurity and other “hot ideas,” you might think that the investment world has moved on from the energy sector. Judging by the industry makeup of the broader U.S. stock market, that certainly seems to be the case. Back in 1980, the energy sector comprised nearly 30% of the value of the benchmark S&P 500 index; today, it comprises barely 3%.
Despite its reputation for being somewhat passé, there are several reasons why an allocation to energy could be a very good idea for your portfolio:
Inflation protection
The rising prices of oil and gas are often noted as a major contributor to overall inflation ‒ an observation that’s obvious to anyone who’s filled up their car over the past several months. But energy companies themselves are often sheltered from this rising inflation: as oil prices rise, so too do their profits.
Little wonder then that energy producers have historically outperformed during high-inflation periods. What’s more, many pipeline and infrastructure companies have long-term, inflation-linked contracts that simply pass rising costs through to customers. Something to keep in mind as we enter an era in which supply chain problems, tariff conflicts and ever-expanding government deficits will likely have everyone complaining about rising costs for some time.
Low correlation to other assets
Longtime readers of this column will know that we’re big fans of diversification: the importance of spreading your portfolio over different asset classes, different sectors of the economy and even different investing styles. The energy sector is a particularly useful tool in this regard, offering performance that often moves independently of the technology and consumer companies which get so much attention these days. That can be a big benefit for conservative-minded investors looking to protect their portfolios against a pullback brought on by sky-high stock market valuations.
Income, baby, income
Many energy companies have long track records of making regular dividend payments. This is particularly true for many of the established companies in the Canadian energy sector: several notable industry-watchers and fund managers have long encouraged Canadian energy CEOs to rein in capital spending, pay down debt and prioritize dividends to investors. These attractive dividend yields make the sector an enticing place for income-hungry retirees or anyone looking for a steady paycheque from their portfolio.
Real asset exposure
Oil and gas fields, pipelines, wind farms, nuclear plants ‒ these are all tangible, long-lived physical assets with concrete economic value tied to real-world uses. That makes them fundamentally different from companies which derive their economic value from technology, intellectual property, communication networks and intangible brands. Real assets are generally more resilient to both inflation (they often rise in value as inflation rises) and severe market crashes (their intrinsic value gives them a “floor price” based on real-world demand rather than on market sentiment). Both of these traits make them an excellent portfolio diversification tool.
Why now: understanding the current opportunity in energy
The energy sector is certainly not an emerging part of the economy ‒ in fact, the history of Imperial Oil, one of the most established of all publicly traded Canadian energy companies, stretches all the way back to 1880. But, over the past several years, a number of trends and economic events have emerged to create a set of intriguing new opportunities for both Canadian energy companies and their counterparts around the world.
Structural demand
The global population continues to rise, and the industrialization of developing countries continues apace. Add to that the rapid electrification of transportation and other sectors, and you have a very strong argument that the long-term, fundamental need for both traditional energy sources and renewables will only increase for many years to come.
Energy security
We live in a time of heightened geopolitical tensions: witness the ongoing war between Russia and Ukraine, continued Middle East strikes and counter-strikes, sabre-rattling by China and elevated tariff and trade arguments around the globe. All of this conflict has highlighted ‒ for many countries ‒ the strategic importance of investing in domestic oil and gas supplies, renewable energy and even nuclear power. For investors, this renewed interest in secure, “home grown” energy has opened up a number of intriguing opportunities around the world that might not have been considered a decade ago.
Years of underinvestment
At the end of the last energy cycle (approximately 2014-2015), many energy companies severely cut capital spending and exploration budgets in order to emphasize cash flow, debt reduction and shareholder returns. After several years, reductions in capital spending have now reached the point at which lack of investment may constrain future supply. This has the potential to support higher prices and stronger cash flow for many producers ‒ at least until the industry starts investing in exploration and production again.
The energy transition
The world has a climate-change problem. And renewable energy ‒ wind farms, solar arrays, hydroelectric dams, geothermal projects, battery storage and even carbon capture technology ‒ is increasingly seen as part of the solution. Despite the best efforts of some governments to delay or derail the expansion of renewable energy projects, the build-out is accelerating. All of this has created some intriguing opportunities for investors, particularly as the costs of renewable technology come down over time.
The nuclear renaissance
Closely related to the above is the so-called nuclear renaissance: a renewed appreciation for nuclear power as a clean, economical, “always-on” energy solution that can complement more intermittent wind and solar power. In recent years, China, India and Russia have started building new reactors, while countries such as Germany and Japan are restarting previously mothballed ones. That means good times ahead for uranium miners, nuclear utilities and the engineering firms which design and build nuclear plants.
Power-hungry AI
You may have heard about the massive energy needs of artificial intelligence: a typical AI data centre requires as much electricity as it takes to power 100,000 or more homes; the much-larger versions being built today may require more than 20 times that amount. To meet our insatiable demand for all things AI, investors expect strong demand for natural gas, renewable energy and power plant infrastructure to continue for many years.
How to invest: different ways to put your money to work in energy
If you’re an investor in Canadian index funds or market ETFs, you probably already have some exposure to the energy sector. The same goes if you’ve paid into the Canada Pension Plan for some years: the CPP has long been an investor in some of Canada’s best-known energy companies (both conventional oil and gas as well as renewable energy). If you’re looking to add to your exposure, however, you have several options, including:
Exploration & production (E&P) companies
These are the companies that many investors think of when they think of the energy sector: the companies that are actively engaged in finding and extracting oil, natural gas and natural gas liquids (propane, butane and similar molecules) from the earth. They range from large, established, multinational producers with long histories and production around the world to small, highly speculative startups hoping to strike it rich with new wells.
Because the price of their product is directly connected to the price of the underlying commodity, the stock prices of E&P companies can be among the most volatile in the sector, often rising or falling dramatically in a single year, or quarter, or even in a single trading day.
Energy transportation and infrastructure
Think pipelines, energy storage facilities, export terminals and processing plants. Unlike the E&P companies, energy infrastructure companies generally offer stable cash flow, with fee-based revenue based on long-term contracts rather than direct exposure to underlying commodity prices. They also tend to have an economic “moat” around their assets; given the costs and permitting challenges of building additional pipelines and infrastructure, those fortunate enough to have existing assets are somewhat protected from competition. These qualities can make them excellent choices for conservative investors looking for reliable dividend income.
Services and equipment
These companies provide design, engineering, drilling and pumping equipment and expertise to the those exploring and producing hydrocarbons. This is a rather cyclical sub-sector of the energy industry, highly vulnerable to the boom-bust nature of energy investing. During good times, services and equipment companies gush cash ‒ during bad times, not so much. For speculators with a strong conviction about the future environment for oil and gas, this can be a lucrative area to play in. But if you’re looking for long-term steady cash flow and reliable earnings, it might be best to look elsewhere.
Royalty companies
Royalty companies are firms that own mineral or commodity rights on a given parcel of land. Instead of developing those assets and producing the underlying commodity themselves, they lease production rights to other companies, taking a cut of the revenue in return.
The benefits of such a structure are easy to understand ‒ because they don’t pay for building, drilling, production or maintenance costs, royalty companies have very low capital expenditure requirements. They typically carry very little debt, which makes them much less vulnerable to financial stress during commodity downturns. It also gives them ample opportunity to pass on cash flow to investors in the form of dividends. Both of these features can make them a more conservative, less risky choice for those wishing to dip their toes into the energy sector.
Renewables
These companies are involved with the continued build-out of clean energy sources: solar arrays, wind farms, hydroelectric dams, battery storage and similar enterprises. As climate change becomes more of an issue, such companies have a bright future ahead of them. But, unlike those involved in traditional oil and gas extraction, changes in government policy, electrification subsidies and technology can have outsized impacts on their stock prices. Make sure that you consider both these factors before committing money to them.
Uranium and nuclear energy
In the wake of the Chernobyl and Fukushima disasters (and for those of us old enough to remember, Three Mile Island), nuclear power was seen by many as menacing and dangerous. Today, it is increasingly viewed as a greener alternative to fossil fuels. This should mean good times ahead for miners and royalty companies operating in the sector.
That said, the workings of the uranium industry often stand quite apart from the rest of the energy sector: thin trading volumes; the geographic concentration of uranium deposits; long lead times for mine development; and strict government regulation which can make the “investment rules” of this sub-sector a little difficult to understand and appreciate at times. Make sure to do your homework and understand the idiosyncrasies before you invest.
Utilities
Regulated companies that distribute electricity and natural gas to end users are the most defensive area of the energy sector. Generally, such companies offer highly predictable returns and long histories of dividend payments, making them an excellent choice for risk-averse investors, albeit at the expense of the sometimes-explosive growth that investors can enjoy in other sub-sectors of the energy industry.
Be aware, however, that many investors view utilities as an income alternative to bonds and other fixed-income investments. When interest rates are low and bonds are relatively unattractive, this tends to push up the value of utility stocks as investors seek higher payouts. The converse is also true: as interest rates go up and bonds become a more attractive choice for income-seeking investors, the stock prices of utilities can sometimes falter.
Funds and ETFs
Of course, most of the above options are available as pooled funds overseen by professional investment managers. Several energy mutual funds and ETFs exist; many of them have specific areas of focus which offer exposure to distinct industry sub-sectors (diversified sector allocation, clean energy and renewables, uranium-focused, etc.). For those who lack the time or knowledge to do their own homework regarding individual energy names, such options offer the benefit of broad diversification and expert-level management ‒ attractive features in a sector known for volatility.
The future of energy: emerging opportunities
Like much of the economy, energy is a sector that is rapidly being transformed by a variety of technological changes. In the coming years, such innovations may end up changing the sector completely and, potentially, your portfolio along with it.
For example, many transportation companies are exploring hydrogen as a promising alternative to electric vehicles. Innovations in battery storage may make renewable energy sources much more viable: the ability to store energy when the sun isn’t shining or the wind isn’t blowing could be a big boon in the effort to replace traditional oil and gas. In the nuclear space, a number of companies are experimenting with modular nuclear reactors: shipping container-sized reactors that are much cheaper to build (and arguably safer to run) than the massive nuclear power plants we know today. And, far out on the innovation curve, researchers are getting closer and closer to a sustained fusion reaction, with the promise of nearly limitless electrical power that comes along with it.
As exciting as some of these opportunities may sound, it’s important to understand that they are by nature speculative: these technologies have a long way to go before we see widespread adaptation. Indeed, some of them may not be fully developed for decades, if at all. That makes them best suited for veteran investors with a strong stomach for volatility. Conservative-minded investors looking to minimize wild mood swings in their portfolios would do best to steer clear.
Understanding the risks: potential pitfalls and caveats
Despite the many benefits of investing in energy, it remains a volatile sector that can be influenced by any number of economic and political factors. It’s important to be aware of these before allocating a portion of your portfolio to the sector. These include:
Commodity volatility
The prices of oil, natural gas and uranium can swing dramatically in response to supply and demand, government policy, geopolitics and the often-irrational, hard-to-understand whims of the market. These price movements are notoriously difficult to predict ‒ even for veteran market-watchers and long-time industry insiders ‒ and can have a significant short-term impact on the share prices of nearly every company that finds, extracts and exports energy.
Geopolitical risk
Energy commodities are among the most influenced by politics around the world. Wars, regional conflicts, transportation bottlenecks and blockades, sanctions, government tariffs ‒ all of these can have more of an impact on the economics of energy companies than anything a company’s CEO can do.
The energy transition
The shift from fossil fuels to cleaner, greener sources of energy is a very real thing, even if it’s taking longer than many people would like. This means that the long-term structural decline in the value of “stranded” fossil fuel assets is a possibility that investors need to be aware of, even though that possibility may be far, far into the future.
Changes in regulatory policy
Many sub-sectors of the energy industry are subject to policy changes, unexpected regulatory reviews and shifts in government subsidies (or their complete elimination). Sometimes, those impacts are easy to predict and understand; at other times, they can be capricious and seemingly irrational. Either way, investors need to know that policy can dramatically change the investment case for a given energy company ‒ something which we’ve seen lately with pipelines in Canada and the renewable sector in the U.S.
Interest-rate sensitivity
Some sub-sectors of the energy industry have large, ongoing capital requirements ‒ pipelines and utilities are common examples, and large E&P producers aren’t far behind. These capital expenditures often require companies to take on significant debt, and that can make them vulnerable to higher interest rates: as rates rise, the cost of carrying that debt can rise too, adding strain to the balance sheet. Rising rates can also make energy dividend yields less attractive when compared to bonds ‒ something that can cool demand for dividend-paying shares.
Environmental considerations
Growing awareness of climate change has increased regulatory pressure on fossil fuel producers and associated infrastructure companies such as pipelines. In addition, carbon pricing regimes and emissions regulations are now significant economic headwinds which most traditional producers will have to consider. All of that pressure has spilled over to the investment industry: many pension funds, endowments and institutional investors are now avoiding investment in fossil fuels in response to the values of their shareholders. Over time, this may depress valuations and increase volatility in much the same way as it has done for the tobacco industry over the past half-century or so.
A final word on energy
While these caveats are certainly worth careful consideration, for investors with well-diversified portfolios and an appropriate long-term investment horizon, there can be little doubt about the compelling long-term story that’s propelling the energy sector forward these days.
When considering bumping up your exposure to any economic sector, however, it’s important to understand how that exposure fits with you: with your current portfolio makeup; your need (or lack of need) for portfolio income; your long-term financial goals; and, especially, your personal risk tolerance.
If you’re interested in putting money to work in the energy sector, make sure that you do it for the right reasons: not because you believe that you have a special insight or “insider tip” regarding where the price of oil is going over the next several months, but because you believe in the long-term importance of energy and its evolving role in powering the global economy. That’s the kind of broad-level thinking which is the first, most important step toward greater success when it comes to achieving long-term investment goals.