Shares sector review – energy

What is the energy sector?

The energy sector is dominated by companies involved in the exploitation of fossil fuels – namely oil, natural gas and coal. These are used to power transportation, provide heat, and electricity. It also includes providers of equipment and services to those companies who extract, refine and sell fossil-fuel derived products.

The sector’s also home to companies involved in the supplying of renewable energy equipment and services, and renewable fuels.

It doesn’t include utility companies who generate and supply electricity to the end users though. However, as we’ll discover, the distinction between which companies do what is becoming increasingly blurred.

How has the sector performed?

Since December 2019, the moment when COVID-19 first tightened its grip on the global population and economy, the FTSE 350 Energy Total Return Index has returned 28%* – a decent outperformance over the FTSE 350 overall. This doesn’t necessarily paint the full picture though. The energy sector suffered for most of 2020 due to falling oil prices, before recovering and performing strongly over the last 12 months thanks to rebounding oil prices.

The performance of the energy sector is broadly in line with the increase in crude oil prices over that period. However, the energy sector’s been significantly more volatile than the wider market, albeit less so than the oil price.

While the oil price has retreated from the highs seen last year, the sector has largely held onto previous gains. This could put some pressure on valuations in the near-term.

Performance - sector Vs FTSE350 Vs oil price

Past performance isn’t a guide to the future. *Source: Refinitiv Eikon and U.S. Energy Information Administration, 30/04/2023.

A sector under fire?

When it comes to climate change, the energy sector is often the first that comes to mind, with fossil fuels contributing to over three quarters of global greenhouse gas emissions. It’s something that big oil has been accused of turning a blind eye to. And while energy bills have been a big part of the pinch households are feeling, the major energy companies have been thriving.

In the UK, that’s been seen as fair game for the treasury who temporarily slapped higher tax charges onto profits by oil and gas companies.

A sector that has to evolve rather than transform

Uncertainty about the future of oil and gas, as well as concerns surrounding the industry’s environmental, social and governance (ESG) risks have held back investor sentiment for some traditional energy companies.

Meanwhile there have been some false dawns for those developing cleaner forms of energy. The fact is oil and gas is likely to be an important part of the energy mix for some time to come.

There’s no shortage of oil in the ground. But the quality of producing wells in terms of both economics and environmental impact is becoming more important than ever. It’s not just usage of fossil fuels that generates carbon emissions. About a tenth of human-made greenhouse gases are generated from the oil and gas industry’s operations.

Only half the likely global demand out to 2050 can be met from commercially viable carbon efficient operations from the industry as it stands today. Even if our energy mix pivots to keep global warming to no more than 1.5°C and reach net zero by 2050, there wouldn’t be enough supply of commercially viable, carbon efficient resources to meet fossil fuel demand along the way.

Paradoxically, to reach net zero targets, huge investment is needed in both existing projects and exploration.

In recent years, coal to gas switching has been one example of where significant reductions in carbon emissions have been achieved. And for now, Europe’s efforts to break its dependence on Russian gas supplies, means there’s a focus on building out the infrastructure to enable imports from elsewhere. This is largely in the form of liquified natural gas (LNG) which can be transported overseas by ship rather than pipelines.

There’s no escaping the fact that to meet net zero by 2050, our energy mix will need to change dramatically and reduce its reliance on fossil fuels. But, the amount we use is likely to rise before it falls.

Chart showing EU final energy demand by 2050

Source: European Commission (2020).

The oil majors can’t afford to ignore the longer-term picture with some of the biggest players setting out ambitious near-term targets for investment in renewables. The demands for investment in both traditional and new sources of energy mean that cash resources can come under pressure, particularly when commodity prices are lower.

The green or black stuff – what’s more important for Shell and BP?

Our view

The energy sector is a rapidly changing landscape. That means for both established companies and newer entrants, it’s hard to be predictable.

The pure play pioneers of technologies that are still to be fully adopted, like fuel cells and hydrogen, have at times reached some extremely optimistic valuations. They’ve come clattering back when delivery hasn’t matched the hype.

The infrastructure of the more established players means they’re well placed to integrate newer sources of energy, and we’ve seen some sizeable acquisitions by the oil majors.

Technologies that can slot into their existing distribution networks, refineries, and retail chains, like biofuels and electric vehicle charging, would seem to make the most business sense. However, the long-term economic returns from these activities remain to be seen.

In the short-term, we still think oil and gas is going to be the main driver of profits. Volatility in oil and gas prices, combined with the growing need for investment, means the generous pay-outs to shareholders seen in recent years could be difficult to sustain.

What’s more, flip-flopping in the boardroom when it comes to pulling back on emissions targets is likely to weigh on investor sentiment. This could also provide additional fuel for activists seeking ever higher taxation on profits.

There’s also plenty of change to face for the providers of equipment and services to the energy sector. The industry is moving away from the frenetic exploration activity on which many of these companies have traditionally depended. However, commissioning additional production in existing discoveries is another factor which drives demand.

On the one hand, a potential economic slowdown is a threat to production. On the other, the drive for energy security in non-Opec+ nations, like the US, could see volumes increase. But ultimately for these companies to have a viable future, they’ll need to pivot away from traditional sources of energy.

Meanwhile, recent production cuts announced by Opec+, the global cartel of oil producing countries which also includes Russia, could lend some support to commodity prices. Of course, predicting price movements with any certainty is impossible. And we think the volatility seen since the turn of the century could well continue.

Longer term, there’ll still be a market for fossil fuels for some time to come. But the wheels of change are gathering momentum, and those who can adapt fastest will likely be the key energy suppliers of the future. Getting there however, isn’t going to be an easy ride.

This article isn’t personal advice. If you’re not sure what’s right for you, ask for advice. Investments and any income from them can fall as well as rise in value so you could get back less than you invest. Past performance isn’t a guide to the future.

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