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As the world hungers for energy, investing in energy-related companies may seem like a good idea. And, indeed, the last decade has been lucrative for this sector, as have other periods in the past. But investors need to understand the risks associated with investing in the energy sector, so here we will assess some of the key issues and threats in this industry. For example, how will high energy prices influence the search for unconventional sources for energy? Is there even a slight chance that the price of oil and gas could decline?
The Price Relationship Between Oil and Natural Gas
Natural resources are finite, yet human ingenuity and technological advances continue to bring more oil and natural gas to the market from sources which were previously inaccessible. A recent example is American shelf gas, access to which has had the knock-on effect of significantly reducing the price of natural gas. Thus the long-lasting price relationship between oil and natural gas has been broken by the introduction of shelf gas.
A reduced natural gas price might very well be good for both the environment and the global economy in the long term, but not so good for production, exploration and development of gas fields, or companies invested in LNG (liquefied natural gas) sea transportation.
Oil supply has stalled since 2005, and growth from regions such as Brazil, the U.S. and Canada merely offsets the decline in the North Sea and Mexico. Further, 50% of "proven" oil resources are in the Middle East, and some 20% in Venezuela. Countries like Iraq, Saudi Arabia and Libya have uncertainties in their oil supply. Peak Oil author Matthew Simmons wrote in his book "Twilight in the Desert: The Coming Saudi Oil Shock and the World Economy" that Saudi Arabia is approaching the peak of its production, and that the kingdom has damaged its oil reserves by pumping salt water to gain short-term production increase. The bottom line is that information about energy reserves and production capabilities are not transparent: many countries withhold information about their wells and the condition of their reserves.
The world also has access to unconventional sources of energy; yet politicians in Europe seem reluctant to bring unconventional oil, e.g. tar sand from Canada, to their borders due to the environmental impact. However, tapping oil from unconventional sources might be tempting for countries possessing it, if the price is high enough. Even if the EU will not touch tar sand oil, as long as someone buys it this new supply will reduce the pressure for conventional supplies.
The demand for energy obviously depends on the world economy. During the last decade, demand has largely come from China, the Middle East and other emerging economies that have experienced demographic shifts, an increase in wealth and, in some markets, fuel subsidisation policies. Demand for energy from rich western countries has actually declined 5.5% since 2000. Morningstar analysts believe that future growth will come from emerging markets in general and China in particular, as China navigates its transformation from investment-driven economy to a consumption-driven economy.
Morningstar analysts project demand growth and tighter supply for oil over the long term, but, for investors, what matters is what is discounted into the price of these offerings, be they public companies or energy commodities.
A History of Volatility
Even if we believe that demand for energy will remain high and long-term supply finite, investing in energy stocks and commodities requires some research. The main issue with the price of energy and shares of energy companies is their high historical price-volatility. Through the 1990s, the price of oil swayed between $20 and $30 per barrel for WTI, but in 2008 it soared to above $140, before plummeting again to $40 later the same year. Currently, the price of WTI hovers just below $100 per barrel. Naturally, when the price of oil swings so violently, it affects both the companies producing and consuming sing it. Investors should also be mindful of national differences in taxation; for example, the Norwegian government taxes income from the Norwegian continental shelf at a rate that others might see as eye-watering: 78%.
In the chart below, we see the rolling 5-year volatility for three indices of energy companies, two of which are U.S.-based and one of which is global. The latter, MSCI World, has been added for comparative purposes--to show the combined volatility of all sectors in the world economy.
For investors, it is essential to remember that past risk tells us very little about the future. The volatility of energy stocks plummeted coming into 2008, which we know was one of the most volatile years in stock market history. However, the previous chart also reveals that volatility in the energy sector does not always follow that of the larger market. From the chart, one can see that the energy sector diverged from global equity markets in early 2004 in terms of volatility. The overall message to take away is that volatility is higher in this sector than in the diversified global equities market.
Investment Ideas
Currently, Morningstar analysts see a number of energy-related opportunities and think the sector is approximately 14% undervalued compared to its discounted cash flows. Note, however, that these figures include alternative energy, which our equity analysts believe are overvalued by some 19 % as of November 1. Looking at individual companies, Morningstar analysts highlight U.S.-based Baker Hughes (BHI), which trades at a price-to-fair value ratio of 0.51, while Petroleo Brasileiro SA Petrobras (PBR) trades at 0.57. Larger companies, such as Royal Dutch Shell (RDSB), ConocoPhillips (COP), and Exxon Mobil (XOM) are attractively priced according to our equity analysts. In fact, our analysts find many interesting cases amongst large integrated energy companies. Most of the sub-sectors, including drilling, exploration & production, refining and oil & gas services are concluded as being attractive at current prices. Midstream (processing, storage, marketing and transportation of oil and natural gas) looks fairly valued. Overall, Morningstar is relatively positive on the outlook of the energy sector.
Investors also have the option to invest more broadly in energy issues, either through a dedicated ETF or traditional fund covering the sector. There are plenty of options, so investors are advised to utilise Morningstar's ETF Quickrank and Fund Quickrank to rank their options according to select criteria, such as Morningstar Rating. First, however, check your portfolio's current exposure to energy using Morningstar's Instant X-Ray tool. Your may find that the manager of your equity fund has already picked up ten stocks from the sector and you are unwittingly covered in this area. Investors active in resource-intensive countries such as Norway, Canada, or Russia are probably already loaded up with energy-related investments issues.
In any case, over the last decade the performance in the energy sector has superseded that of the MSCI World. Will that hold true for the next decade? That depends on a number of factors, such as technology, the global economy, demand from emerging markets, supply from volatile regions, and the use of unconventional sources. Morningstar analysts see most subsectors as attractive, with the exception of alternative energy. High switching costs, declining production from the North Sea, questions regarding global spare capacity and expected demand from emerging markets makes Morningstar analysts positive overall on the prospects of energy-related companies.
