The worst-performing US stock market sector in 2019 is energy. In retrospect, we regret that we held a position in it. Our rationale failed so far and the timing was clearly poor. But we did hold energy and we do still do.
Our focus has been on domestic US energy because we believed it is (and was) insulated from geopolitical risk. We also see the US’s potential as a large exporter of energy, including liquefied natural gas (LNG). As a matter of fact, Prof. Adam Tooze tweets, citing a Financial Times report, the “US exported 89,000 more barrels of crude oil and refined petroleum products a day than it imported in September = 1st full month of a positive oil trade balance since the 1940s. Ten years ago imports exceeded exports by 12m barrels a day a decade ago. (Adam Tooze, https://twitter.com/adam_tooze/status/1200784043924738048?s=21
But the US energy stocks haven’t reflected any of this positive evolution. Why? Is it that US reserves have expanded faster than export-led sales have? Maybe. We have, however, also watched repeated delays in the completion of the pipeline and terminal infrastructure needed to fulfill the LNG export opportunity. And we also see (and saw) that China wanted to buy LNG from us. They need it. We have it. Our American energy companies want to sell it.
So, what’s in the way? The demand from China and elsewhere abroad is still there. And our abundant supply can be exported at low cost. Remember, we are at record high exports and the number is rising. The missing link is the ability for US producers to engage in reliable long-term LNG contracts with foreign buyers. And the biggest would-be buyer is China. Right now, longer-term contracts between China and the US are on hold. The Trump Trade War has killed them. The same is true with other countries, but China is a biggest energy buyer, sitting in the wings.
In addition to the US-China elements, the energy sector is buffeted by the OPEC price-setting mechanism and also by the changing characteristics of the oil business as Saudi Arabia monetizes some of its investment with the Aramco offering. In a fully functioning, non-trade war restricted global environment, all this would work to the advantage of the US energy sector. That is why the energy sector rallies every time there is a news item suggesting a trade war truce is coming.
The result of the trade war turmoil is that the energy sector in the S&P 500 Index has fallen to its lowest relative weighting in many decades. It is close to 4%. At its peak weight in 1980, when the first energy shock brought the oil price to $30 a barrel, the US energy sector was close to 25% of total market weight. Think of that figure and realize that the entire tech sector today is about 22%. Energy is clearly a most beaten-up sector.
Meanwhile, the world’s energy demand from fossil fuel sources continues to rise, even as the pursuit of cleaner non-fossil alternatives intensifies. So, too, do the latest estimates of fossil fuel output continue to rise. While we believe any acceleration in global climate change is going to dampen that trajectory, we also know that large-scale changes in the oil industry are hard to make and that the climate skeptics still have a strong voice in the “no changes” camp. The United States is currently in that camp, given Trump’s withdrawal from the global climate-change conversation.
To emphasize the difficulty in making large changes in fossil fuel use, I will cite the Economist (pg. 73, November 23, 2019) and the data from 188 countries that pledged to curb their greenhouse-gas emissions. The research examined the internal approvals and documents from each country and compared them with the pledged reductions by country. Actual output went up in spite of the pledges to reduce. The Economist cites data from the United Nations Environment Programme and states that “global CO2 emissions from fossil fuels will reach 41 gigatonnes by 2040 which is 5 gigatonnes higher than the 36 gigatonnes pledged. Meanwhile, scientists estimate that 19 gigatonnes or less is required to keep global warming limited to 2 degrees centigrade.” (Paywall: https://www.economist.com/science-and-technology/2019/11/23/fossil-fuel-producing-countries-say-one-thing-and-do-another)
So like it or not, the production and consumption of fossil fuels is headed higher. Markets are ignoring this data.
An additional item that seems to be a continuing puzzle is the low geopolitical risk premium in oil. It persists even after the Sept. 14 attack on Saudi oil facilities and other ongoing hostilities in the Persian Gulf and throughout the Middle East. It would appear that market agents are pricing geopolitical risk at a low level because the world’s inventories provide a cushion that market agents believe is sufficient to make up any interim gap. This thesis was supported when the Saudis delivered oil from their inventories as they brought their disabled facilities back online after the drone attack.
At this point we have alternate scenarios regarding our energy investment position, so our forecast for year-end and 2020 is clouded by these crosscurrents. We would prefer a “greener” outlook, as we are climate change believers. But we are also investment advisors and have to respect data and not wishes. We hope for a cleaner world. But in the market space, hope is not a strategy.
Right now, we are still holding some domestic US energy positions. Those positions focus on four factors: 1. Domestic US; 2. Some natural gas; 3. Some solar; 4. Some wind. Also note that there are only a few ETF choices in the non-fossil fuel space so details within the ETF are important. Also note that there is a growing movement to raise asset allocation in favor of non-fossil fuel sources. This suggests positive investment inflows into the ETFs that capture the cleaner (or less dirty) energy sources.
On Friday, March 20, 2020, I'll be participating in a program, "An Outlook on Energy Policy," in partnership with the University of South Florida Sarasota-Manatee. The half-day conference will explore investing, government affairs, alternative market solutions, as well as its effect on the Federal Reserve and Fed policy. If this interests you, please visit the Global Interdependence Center's website for more details: https://www.interdependence.org/events/browse/an-outlook-on-energy-policy/
David R. Kotok
Chairman and Chief Investment Officer
Email | Bio
Read the full series of "Year-End & 2020 Forecast Notes" by David R. Kotok at this link (updated as they are published):
https://www.cumber.com/cumberland-advisors-market-commentaries-year-end-2020-forecast-notes-by-david-r-kotok/
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