A curious beer, and a curious idea

As I left the pub last night at 21:59, I was asking my friend about the curious beer he had ordered.

It was an unusual concept, where half a pint of bitter had arrived in a pint glass, alongside a bottle of light lager which you then pour in. Apparently, it’s a reasonably well-known concept called a light and bitter.

This morning, it got me thinking about the balance we all need, in our portfolios.

And that perhaps, to provide diversification, you don’t even need to look at more than one sector.

Perhaps one area of the markets can offer a genuinely hedged, balanced equity allocation. An investment cocktail where the alcohol and the mixer are one and the same.

Could oil and gas stocks be a hedge against green energy and vice versa? Side by side, could they balance an equity portion of a portfolio?

After all, one rides on the crest of the tech wave, while the other waits for a recovery in the real economy.

One has exceptional value but enormous size, while the other has a very small market capitalisation, but some pretty lofty price-to-sales ratios (if they have sales at all).

And this year we’ve seen an extraordinary divergence in performance.

How can this be? Both are essentially trying to do the same thing – power our phones, cars and factories.

Our original Beyond Oil guest, Gregor Macdonald, recently outlined in a Twitter thread his view that battery storage, as it becomes the key element of power management and distribution, will render solar and wind into something like commodities – inputs into the energy storage-based grid.

Source: Gregor Macdonald, on Twitter

So why is it that two things, so similar in end-function, can have become such different assets in the minds of investors?

Well firstly, there is the classic structure of the new vs the old.

New technology offers promise (via uncertainty). Higher risk, but higher reward, and for the last few years, people have a pretty ravenous appetite for risk in some corners of the market.

The narrative of oil and gas majors is that they are past it, they are the dinosaurs, the fossils in more ways than one.

Coronavirus has exacerbated this emerging theme even further. To invest in fossil fuel assets is to be backwards-looking and clearly, foolish.

But advocates though we at UK Uncensored are of the energy transition both as investors and climate-conscious citizens, my contrarian instincts start tingling when assumptions start to gain mass adoption, and I think people might be giving up on oil and gas too soon. To find out though, we need to understand when and why the two themes diverged.

In years gone by, the prevailing narrative was that if oil and gas prices fell, this lowered the imperative to seek “alternatives” – as clean energy sources used to be known.

Now they are by no means “alternative”, as they are bordering on mainstream domination in many countries.

That old narrative meant that when oil and gas prices fell, so did the stock prices for “alternative” energy stocks, as people would be less interested in their solutions if oil was at $60 per barrel instead of $100. There was “competition”.

But since 2018, this core narrative has moved on somewhat.

What we have now is a new narrative, whereby the fortunes of the two are diametrically opposed. If oil is doing badly, investors see financial pain for oil and gas majors and so they are turning to clean energy stocks instead.

Or even to the energy majors who are transitioning the most aggressively, such as Equinor or Orsted, (formerly Statoil and Danish Oil and Natural Gas).

After all, most clean energy stocks are too small for most institutional funds. That’s why there are very few listed funds offering true clean energy equity investments, and why those which do exist all invest in very similar stocks – your Teslas, NextEras and Iberdrolas.

What we now have is a situation where clean technology stocks, which are early-stage, fast-growing stocks based on new technologies, are rising rapidly in price to very high valuations. Sometimes these are ludicrous, Tesla being the most famous culprit, but there are plenty of others too.

Meanwhile, oil and gas major trade on single P/E ratios and price-to-sales ratios around or below 1. Some midstream companies, with master limited partnerships (MLPs) being a common example, are offering extraordinary yields at puny valuations, with decent dividend cover and respectable balance sheets. True value opportunities.

As a result, you have companies looking to achieve the same thing essentially – the creation of heat, electricity and propulsion for the end user – but which have opposing investment characteristics.

One is growth, the other is value. And as we know, growth (blue line) has never been so expensive relative to value (red). The value of value is at extreme lows relative to history.

Source: Koyfin

If you are a growth investor, you are paying for the growth inherent in clean energy stocks, growth which they are delivering because they are new and young.

Because economic growth has been pretty anaemic this last decade, that growth commands a high premium.

The value assets offer opportunity in a very different scenario, where economic growth arrives in the form of construction, and high business activity. If economies do bounce back quickly, it is still to oil and gas that they will turn, and any improvement in demand in the real economy will directly benefit the oil price, its extractors, refiners, transporters, and retailers.

Growth is hard to come by when economic growth is as low as it has been since the financial crisis in 2008, hence why companies which offer growth have received so much attention (and capital).

But in a world of rising oil prices, be it from increasing demand if economic growth picks up, or under-supply because of all the cuts we are seeing made this year, then fossil fuel companies too will offer earnings growth in a low-growth environment, and demand similar premiums for doing so.

It’s possible therefore, that like a pint of light and bitter, combining the two energy themes together in a portfolio could provide a reasonably balanced approach. It could position you for both continuity and change, with the irony not missed that it’s the oil and gas assets which are the hedge against change, and not the disruptive new energy stocks.

So, what’s the final verdict? How have these two halves of the same coin matched up from a performance perspective? Here’s a five-year chart of the leading clean energy ETF (blue line) vs the leading US oil and gas ETF (red):

 Source: Koyfin

Clearly there is an anti-correlation, with the three key examples highlighted.

Well, it’ll come as no surprise to any of you that oil and gas has dramatically underperformed of late. Since its post-2016 rally fizzled in late-2018, it has slid lower and lower.

The last few years have been so interesting though, because for the first time, clean energy has not followed suit, for the reasons outlined in discussing the change in narrative above.

Will it continue? Can both return to growth together, or as in Harry Potter, is it the case that “neither can live, while the other survives”.

Has someone checked under Trevor Milton’s fringe to see if there’s a lightning scar under there?

Best wishes,

Kit Winder
Editor, UK Uncensored

1 Comment
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