Clean Energy is in. Dirty Energy is out…
Or so they say.
Can you picture that day where children will go outdoors, take a deep breath of fresh clean air, and play in the fields with wind turbines on the horizon, before going home to drink a hot chocolate which was powered by the photovoltaic roof?
If you listen to the media, and to the markets, this day is just around the corner.
In the meantime, renewables have been having their minute in the limelight.
Solar and wind producer Nextera Energy (NEE) became the largest energy company, eclipsing both Exxon and Chevron (CVX). In some parts of the world, with generous policies to push a shift towards renewables, solar is now the cheapest source of energy available . Of course if you remove the subsidies, and the financing incentives, that no longer applies.
Clean is in. Dirty is out. Right? The market sure thinks so.
Not so fast.
When something good or bad happens to the market, to a sector, an industry or even an individual stock; the most important question an investor can ask is: will this last or is it temporary?
Or to use fancy terms, is it secular or is it cyclical?
The rise of renewables is clearly a secular trend. More and more governments will continue pushing for solar and wind.
The decline of oil and gas however, isn’t secular. At least not yet, and not for the foreseeable future. The events which are transpiring in the sector are purely cyclical. Unless you believe that the current world order of lockdowns and limited travel will last for the next two decades, demand for oil will recover and grow within the next few years.
In fact, global demand for oil is still growing, and will continue to grow for at least 10 years, my estimate is more likely 20 years, because the path to renewables isn’t as obvious as media and politicians want you to believe.
Investors need to wake up and see the forest from the trees. The pullback in demand of oil this year is definitely disruptive to the sector, but it will recover within 2 to 3 years. Then, we will likely see consolidation in this sector, which will lead to scale benefits for the highest quality assets. 10 to 20 years as demand matures, oil and gas will have undergone much consolidation, and will shift from a growth business to a rent seeking business, much like tobacco is becoming today.
In this article, I will consider three reasons why the transition to renewables won’t be a walk in the park.
I will then explain that the current downturn in oil and gas is cyclical, not secular.
Finally I’ll consider what this means for investors, with a number of actionable insights derived from the article.
The clean transition is a bumpy, uncertain road.
Climate change is a real threat to the planet. If our hunger for growth doesn’t subside (it won’t), we have to significantly curtail carbon emissions to avoid disastrous outcomes for the planet.
But doing this comes with challenges which the market is not recognizing today.
With renewables at all time highs, and oil & gas stocks at all time lows, the market is pricing that the transition from dirty to clean is a done deal. We’re not there yet. We’re not anywhere close.
Even if it is necessary, it isn’t a done deal.
The transition to clean energy has many obstacles, namely:
- Pollution tied to clean energy infrastructure.
- Geopolitical power plays, namely the Chinese threat.
- Political reticence to take bold action
1. How clean is clean energy?
The rush to create solar panels and wind turbines has not considered the environmental threat that these sources of energy also pose to the world.
This is maybe best encapsulated by an article published on Foreign Policy, where the author stated:
The phrase ‘clean energy’ normally conjures up happy, innocent images of warm sunshine and fresh wind. But while sunshine and wind is obviously clean, the infrastructure we need to capture it is not. Far from it. The transition to renewables is going to require a dramatic increase in the extraction of metals and rare-earth minerals, with real ecological and social costs.
In 2017, the World Bank questioned the required metal extraction to generate 7 terawatts of energy by 2050, or an estimated 50% of the world’s energy.
Without exaggerating, it would lead to dramatic increases in the extraction of multiples metals. For instance it would likely require silver extraction to go up by as much as 100%. Indium could see extraction increase 920%. Both are essential to creating solar panels.
The author of the aforementioned article says that just to produce enough silver to transition half of the world’s energy to renewables, we’d need to commission 130 mines the size of the Mexican Penasquito mine, the largest silver mine in the world which spans 40 square miles. It is operated by Newmont Corp (NEM)
Then there are the lithium batteries required to store all this energy. Lithium extraction would need to increase 2700%. Lithium requires 500,000 gallons of water to produce a single ton. This is already robbing communities in places like Chili from water.
The creation of the infrastructure required to produce “clean” energy is a potential ecological disaster. We are already well ahead of sustainable levels of extraction. And this simulation projects renewables to cover only 50% of the world’s demand for energy. This would already be extremely taxing, and bring on new consequences that have yet to be truly considered. If half of the energy coming from renewables would cause an extraction crisis, where do you think the other half of energy will come from? But I’m getting ahead of myself.
Then there is the question of how we dispose of this infrastructure at the end of the useful lives.
Earlier this year, the BBC run an article titled “What happens to all the old wind turbines?”
The answer isn’t pretty. Most of the wind turbines can be recycled, but the blades can’t. At the end of their 20-25 year useful lives, they are simply buried.
While the sight is not pretty to see, for wind turbines, it is not that big of a deal. They are landfill safe.
This is not the same for solar panels. They contain hazardous chemicals that can leak out into the ground.
Right now, there isn’t enough solar waste for a proper recycling program to emerge. Politicians and green energy fans are hiding behind the promise of recycling facilities in the future. I don’t know why, but I don’t buy it.
Actually I do know why. The world has been pushing to recycle plastic for decades. Do you know how much plastic actually gets recycled? Only 9%. There might be 60 million tons of solar waste lying in landfills within the next 30 years.
Of course, this analysis needs to be compared to the impacts of fossil fuels.
The sustainable answer suggests an energy mix, not 100% solar and wind. The dependence on fossil fuels must decline, nuclear needs to become a bigger part of the mix, but to believe that a world that runs 100%, or even 50% on solar and wind doesn’t cause another set of disastrous consequences is just short-sighted.
This will cause trouble in upcoming decades, when these problems are highlighted.
2. The Chinese threat
A common theme this past decade has been the emergence of China as the new world leader. Ray Dalio surely thinks China’s turn is here. He can be quoted in a recent article on the Financial Times, saying:
“In the long run, timeless and universal truths determine why countries succeed or fail. In brief, empires rise when they are productive, financially sound, earn more than they spend, and increase assets faster than their liabilities. This tends to happen when their people are well educated, work hard and behave civilly. Objectively compare China with the US on these measures, as I chronicle in an ongoing study, and the fundamentals clearly favour China.”
There is much talk of whether the world will emerge post pandemic without a global leader, or whether the US will be replaced.
China’s long term Belt and Road initiative underlines China’s intentions to grow its political and economic dominance. The umbrella initiative which aims to connect people, goods and investment throughout Eurasia aims to put China at the center of future development.
That China will grow its political and economic clout now seems unavoidable. Yet this doesn’t imply the demise of America.
America still has a lot going for it: wealth, cultural domination through widespread media – Netflix (NFLX) – and technology – Facebook (FB) and Google (GOOG) – which gives it long lasting soft power. I for one, as a non American, would not bet against America.
However, in the 21st century, it is important that America retains its independence on multiple fronts. One of these fronts is energy independence.
During the past decade, there has been much talk of America reaching energy independence. In 2019, for the first time since 1957, it was energy independent.
Energy independence also boasts possible geopolitical benefits. The United States imports most of its energy from countries where political tensions run high. Saudi Arabia, Iraq, China and Russia are all huge exporters of energy, and this has put the United States in more than one awkward position over the years.
Now you might ask how a change to renewables changes this, right? After all you’re turning off one source of energy, and turning on another source.
The problem comes from the resources required to create the infrastructure, be it panels, turbines or batteries.
We mentioned lithium in the previous section. Over 50% of the lithium reserves can be found in what is known as the “lithium triangle” between Chile, Argentina and Bolivia. That’s not China though right?
You’d like to think that, but you’d be wrong. The US Energy Resource Governance Initiative found that China controls 80% of all rare earth resources required for electric vehicles and wind turbine components.
China controls 51% of the world’s chemical lithium, 62% of chemical cobalt, and 100% of spherical graphite, the 3 components required to create lithium batteries. Yes, you got it right, you cannot make a lithium battery without China.
This means that unless the US can secure its own sources of rare earth minerals, and enough to replace its fossil fuels, it cannot rely on clean energy and have true energy independence. Tesla (TSLA) is trying to secure its own source and move into mining.
This strategic threat will likely dampen the actual transition from fossil fuels, as the US, which is finally energy independent for the first time since 1957, is unlikely to want to relinquish this independence, especially in favor of the challenging dominant force.
3. Governments are pushing for a transition…sort of.
In the last presidential debate, Joe Biden mentioned a transition away from fossil fuels. It is important to understand what he actually plans on. Electricity net zero carbon emissions by 2035 doesn’t really make a dent. Electricity accounts for less than 1% of America’s use of petroleum.
For natural gas, it is more significant at about a third of demand.
While the Republican party has a vested interest in presenting Joe Biden as the death of fossil fuels, this really isn’t the case.
For one, if Biden is elected, he will have very little say in what the energy landscape will look like in 2035. This is not China, a president only gets 4 years in office and 4 more if they are re-elected. Yes he can make some moves to incentivize more renewable energy, and limit fossil fuels, but like he said “we’re not getting rid of fossil fuels for a long time”.
When faced with the complexity, the threats, and the uncertainty, it is very likely that the status quo will prevail for longer than it needs to. A recent article published in Foreign Affairs looks into why politicians fail to respond swiftly and effectively to different crises. The author sums up our tendency to just keep doing the same thing.
Crises typically require navigating between risks. […] With climate change, they seek a balance between avoiding extreme weather and allowing economic growth. Such tradeoffs are hard as it is, and they are further complicated by the fact that costs and benefits are not evenly distributed among stakeholders, making conflict a seemingly unavoidable part of any policy choice. Vested interests attempt to forestall needed action, using their money to influence decision-makers and the media. To make matters worse, policymakers must pay sustained attention to multiple issues and multiple constituencies over time. They must accept large amounts of uncertainty. Often, then, the easiest response is to stick with the status quo.
We all know that there is a difference between a campaign promise, and what actually gets done.
My guess, with all the complexity and strategic threats, we’ll stick to the status quo longer than is good for us.
The biggest problem for oil & gas is cyclical
When we consider the three points above, it becomes apparent that the biggest problem for oil & gas is cyclical, not secular.
That means that we are looking at least at one to two decades of growth. And beyond that, the U.S. Energy Information administration “projects in the Annual Energy Outlook 2020 Reference case that liquid fuels (petroleum and other liquids) will account for about 35% of total U.S. energy consumption in 2050, compared with 37% in 2019.”
The market is pricing a secular downturn that just doesn’t exist.
This doesn’t mean it won’t be a tough couple of years. It will. The oil & gas industry still has a lot of headwinds in the current cycle.
Balance sheets are highly leveraged, which means that the much needed consolidation is not happening. Companies are focusing on improving their balance sheets, or are in straight out survival mode. The only significant offer in the space has been Chevron (CVX) planning to buy Noble (NBL).
Without a return of demand which is unlikely until a return of travel and transportation, which itself is unlikely until a wide vaccination campaign and a return of consumer confidence, it remains likely that supply will continue to struggle.
This year has gone from bad to worse, with bankruptcies increasing monthly.
With nobody to step in and purchase the assets, bankruptcies will continue to plague the sector in the next year or two.
“Lack of capital is problematic. Lack of investor interest is problematic. And an excess amount of distressed assets is problematic”, to quote a Moody Analyst in a recent FT article.
The median energy stock is down 45% during the past 12 month period.
This places the sector median at the 16th percentile of all US stocks. The whole sector is extremely distressed.
But investors need to remember the words of Howard Marks, founder of Oak Tree Capital (OAK):
There are two concepts we can hold to with confidence: – Rule No. 1: Most things will prove to be cyclical. – Rule No. 2: Some of the greatest opportunities for gain and loss come when other people forget Rule No. 1.
Everybody has forgotten Rule No. 1.
Opportunities for investors.
I hope that the previous 2500 words have helped you get a clearer picture of the clean energy vs fossil fuels debate.
There are many opportunities for investors as a consequence of this, let’s consider a few of them. Some will apply directly to dividend investors. Others fall beyond the scope of dividend investing, but still should be considered.
1. The secular rise of renewables.
The obvious one, is that the secular increase in renewables is happening. They will also have cyclical ups and downs. They are currently having a cyclical up, and most assets are overpriced. Companies like NextEra Energy are on my watchlist, but the dividend yield just doesn’t add up with the companies potential of dividend growth.
The stock is at a crazy all time high. Based on the past decade of dividends, a fair range of yields is somewhere between 2.62% and 3.3%. The current yield of 1.8% suggests strong overvaluation according to our MAD Chart.
It can get much more expensive before it adjusts downwards however. Yet for dividend investors as myself, an investment at this price would go against what I stand for: getting a good deal.
Other renewable plays also seem expensive right now . Brookfield Renewable (BEP) trades at historically low yields.
Nonetheless, the secular wave isn’t going anywhere, and sooner or later, something will go wrong and the industry will become attractively priced.
When this happens, I have these stocks on my watchlist.
2. Long term demand for rare earth materials.
The scale at which it will happen depends on the scale at which renewables are pushed. What is certain is demand for silver, lithium and other rare resources will grow.
For lithium, you’ll have to settle for indirect exposure, through stocks which produce lithium. Albemarle (ALB) is one such example, although its low yield of 1.6% and dividend growth of just 5%, doesn’t make me particularly excited. Other pure plays like Livent (LTHM) are pure speculation. Purchasing an ETF like the Global X Lithium & Battery Tech ETF (LIT) is also quite unsatisfactory. Maybe an attractive way to play this secular trend will appear, but it is not here yet.
Buying silver on the other hand is as easy as putting in an order for the iShares Silver trust (SLV). If commodities are part of your asset mix, holding some silver makes sense in light of its ever increasing.
It is important to note that I do not see silver or gold or any other precious metal as competing for space with my dividend investments. Rather it competes with different currencies for my cash reserves, which I hold separate from my equity investments.
3. High quality Oil & Gas companies: get woke or get paid.
If you are unsatisfied with the two former insights, so was I. Thankfully this next one is a lot better.
With valuations in the energy sector as low as you could ever imagine, high quality assets are on sale. We’ve assessed that although this downturn for Oil & Gas is brutal, it is cyclical and not secular. Therefore buying the assets which will prevail and thrive in the next upswing is a pursuit worthy of my time.
You’d be hard pressed to find value in renewables, yet in high quality oil & gas names, value abounds. Not that anybody believes this. Energy is only 2% of the S&P 500 (SPY).
Robert & I have three picks:
Chevron is the highest quality major you can buy and it yields 7.7%.
Can it go any lower? Sure. After all the price dipped into the low 50s earlier this year. But consider that the dividend is safe, sentiment couldn’t get any worse, and the dividend is well covered by a superior balance sheet and set to grow this year. A yield of 7.7% is a no brainer, I expect a reversal to a 5% yield in upcoming years at a minimum. This suggests upside of 54%. But yes you might have to grit your teeth in the meantime.
Another great stock with a crazy yield: Enbridge. The company’s resilience is unparalleled. The Canadian pipeline company offers an impressive 8.4%.
Enbridge could easily double from the current levels, as its 5-7% projected growth in cashflow easily supports a 4% to 5% yield.
Like I pointed out in a recent article on high yielding stocks, ENB is resilient, well capitalized, continuing to generate large amounts of cash and well positioned to profit from consolidation in upcoming decades.
Finally there is Oneok. Back in May, Robert doubled down on OKE, betting on the fact that the dividend would not be cut. As months have passed, it becomes apparent that the dividend most likely will not be cut. In the third quarter, OKE generated enough distributable cashflow to cover the dividend 1.3x.
OKE was part lucky in timing, part unlucky. It had a lot of new projects coming live in 2020. This caused the company to enter the year with rather high leverage. This made the situation complicated. On the other hand, these new projects meant that in Q3, the company was generating enough cash to support its crazy high 13% dividend yield.
OKE has been here before, and I bet that they will see it through again this time around. Of the three picks, it is the most speculative.
While I have no doubt that CVX and ENB will maintain their dividend, I believe there is maybe a 30% chance that OKE will have to cut.
4. Ditch speculative energy companies.
If buying the highest quality energy companies is a good idea, anything that is subpar and runs a chance of going out of business should be ditched. As we saw earlier, more bankruptcies will come. If there is any chit chat that the company you are looking at could go bankrupt, you want to look at it really closely and ask yourself it you’d be better off taking a loss.
5. The rise of China.
The last actionable insight is the rise of China. Because of anti-Chinese bias, we all have very little exposure to Chinese stocks. I made the choice years ago to invest in American stocks, because nobody is as good as capitalism as America. This has mostly paid off, with markets in Europe and emerging markets being mostly sloppy.
However it is a question that I do ask myself frequently. I have yet to pull the gun. One way to gain some exposure would be to buy an ETF and forget about it. I’d have to do this in a way that doesn’t derail my dividend goals. A couple of popular ETFs are the iShares China Large-Cap ETF (FXI) and the iShares MSCI China ETF (MCHI).
6. Bonus idea. Blackrock (BLK)
When considering macro shifts and how investors can play them, ETFs always come up as the obvious way to play a trend. I’m not a macro investor for the most part, although this macro analysis served to confirm the intuitions I had about the energy sector. Since ETFs will continue to play a large part in the markets of the future, Blackrock can expect to do well for years to come. That being said, like all assets it is subject to getting overpriced. I have recently sold part of my position, and will consider buying more when the tide turns.
Clean energy is on the rise. But fossil fuels are not on the decline. Energy stocks will have challenges in the upcoming years, and they will always suffer from the rise of ESG investing, or woke investing.
Fellow Seeking Alpha author, Chris Demuth Jr. pointed out the ESG trend in his recent article.
In the next few years, investors will have a choice: get woke or get paid.
I have made my choice.