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. Finance 30 | www.snowbirds.org
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