Why Energy Is Back in Fashion

Investing Daily Article of the Week

by Robert Rapier, Investing Daily

The last time the energy sector topped the annual returns for S&P 500 sectors was 2007. In fact, from 2004 to 2007, as oil and natural gas prices broke new ground, energy was the top performing S&P 500 sector in all years but 2006, when it slipped to second place.

Since 2007, the energy sector has been in the bottom five during four out of six years, and never finished higher than 4th place. After turning in the 3rd worst sector performance in 2013 (albeit still with a gain of 22.3 percent), the energy sector could return to the top of the list this year. (And if you have forgotten what a bear market can do to your portfolio, look at the returns from 2008.)

Thus far, 2014 has marked a return to the top for the energy sector. As Bloomberg notes, $5 billion has flowed into the energy sector via exchange traded funds (ETFs) this year, which is an astounding 17 times more than in the final quarter of 2013. So far this year the energy sector has taken 63 percent of all the money flowing into sector ETFs, and the Standard & Poor’s Energy Index has been setting record highs.

A rising tide may lift all boats, but our objective – which we achieved in 2013 and so far in 2014 in The Energy Strategist portfolios — is to outperform the sector indexes whether the tide is rising or falling.

Energy is such a diverse sector that there are always opportunities regardless of the broader sector performance. Thus, I don’t attempt to time the sector, but seek instead to find the best opportunities within.

Over the course of the past year, more and more energy companies began to look undervalued, so I am not surprised at this influx of new money into the sector. But it will be more challenging to find good picks in the months ahead as this money rotation into the sector should fully value many of our favorite companies.

It may seem a bit ironic, but on the day that the National Climate Assessment report was released, the Standard & Poor’s Energy Index reached a new record high. This index of 44 companies includes major energy names like ExxonMobil (NYSE: XOM), Chevron (NYSE: CVX), ConocoPhillips (NYSE: COP), Halliburton (NYSE: HAL), Kinder Morgan (NYSE: KMI), Peabody (NYSE: BTU) and Valero (NYSE: VLO). All of the companies in the index produce or enable the production of fossil fuels, which end up as carbon dioxide in the atmosphere.

Why the disconnect between urgent calls to take action on climate, and all the money pouring into fossil fuel companies? It’s because demand for energy continues to grow, but the money hasn’t flowed evenly. Per the aforementioned Bloomberg article:

“Natural gas companies also will be the first beneficiaries of President Barack Obama’s climate policy, which has consistently discouraged the use of coal without requiring renewables to be used as a substitute, said Stephen Smith, executive director of the Southern Alliance for Clean Energy in Knoxville, Tennessee.”

Regular readers know that I have been beating the natural gas drum for more than a year now. One of the factors behind my bullishness is that natural gas is a much cleaner fuel than coal, and regulations are going to increasingly tighten the noose around the latter. According to the US Environmental Protection Agency, the average air emissions from natural gas-fired power are half as much carbon dioxide, less than a third as much nitrogen oxides, and one percent as much sulfur oxides as the emissions from a equivalent amount of coal-fired generation. So trading coal for natural gas looks like a very attractive option for slashing our carbon emissions.

In a future where the world treats climate change as a crisis and acts — as the National Climate Assessment urges — the options are fairly limited because the world will continue to demand energy. Coal is by far the biggest threat. A 2012 paper by Neil C. Swart and Andrew J. Weaver that was published in Nature Climate Change showed that a whopping 80 percent of the potential climate warming is tied to the potential use of coal. Thus, lower emission replacements for coal are imperative.

The options are fairly few. While renewables like wind and solar will continue to grow exponentially, they are growing from a tiny base and still provide a small fraction of the overall power supply. Further, baseload power is needed due to the intermittency of wind and solar and the inadequacy of current  energy storage options. That leaves nuclear power and natural gas as the two scalable, baseload power options for displacing coal. Each has its critics on environmental grounds, but unfortunately we don’t have a totally consequence-free, massively scalable alternative. Natural gas has gained ground from coal, and is expected by the US Energy Information Administration to continue to do so.

Utilities in the US have begun to switch to natural gas (although there was some backsliding last year as natural gas prices rose), and this is a major factor behind falling carbon emissions in the US. Carbon dioxide emissions fell by 217 million metric tons (MMT) in 2012 to lead all countries. Over the past five years carbon dioxide emissions in the US have fallen by 738 MMT, a decline of 11 percent from 2007 levels, once again placing the US in the global lead.

One caveat is that certainly these declines are coming from a very high starting point. But we have been headed in the right direction, and should continue to build on these recent successes. And we will try to continue to invest accordingly.