In the spotlight: the energy sector

  • Tensions in Ukraine have put the energy sector in the spotlight
  • The MSCI World Energy index is up 59.1% over one year compared to a rise of 17.03% in the MSCI World index.
  • In contrast, energy transition companies have been weak

The energy sector is in the eye of the storm. The tensions in Ukraine have shone an uncomfortable spotlight on the vulnerability of Western energy supply, particularly in Europe. Energy prices had already been rising as supply shortages collided with surging demand in the wake of the pandemic. This drama is set against the backdrop of the energy transition, as countries move to net zero.

This means there is a lot in motion in the energy sector. BP and Shell have seen their share prices more than double since their late 2020 lows. The MSCI World Energy index is up 59.1% over one year compared to a rise of 17.03% in the MSCI World index. It has also seen a surge in the short-term - 15.54% over the past month, compared to a decline of 5.27% in the MSCI World index.

However, the strength has largely been confined to fossil fuel companies. After surging higher in 2020, clean energy companies saw a slump in early 2021 and have plateaued ever since. The iShares Clean Energy ETF, for example, is down 23.8% over one year. Bellwether clean energy stocks such as Vestas Wind, the world’s largest maker of wind turbines have struggled with higher costs and supply constraints.

What happens next? First, it is worth noting that the energy sector is not yet attracting the giddy valuations of, say, the technology sector. Its outperformance is still relatively new and, in many cases, does not take share prices back to their pre-pandemic levels. Shell, for example, was trading at over £2,500 per share prior to the pandemic and has only just tipped over £2,000 today. Its price to earnings ratio remains undemanding, at around 10x. This would suggest there is room to grow.

The energy transition is an important factor for these stocks. Many will need to deploy vast amounts of capital to move away from fossil fuels and ensure the long-term viability of their business. BP has said that 40% of its investment will be going into its five transition growth areas by 2025. Investors have seen this as a key risk for these companies and this has kept share prices lower.

Another risk is the prospect of a windfall tax. Governments are acutely aware of the cost of living crisis faced by many of their citizens. The UK government has announced a £9bn package to help people through the difficult few months ahead. Rising energy prices have been a key contributor to these costs and the temptation for policymakers is to look at the bumper profits from the energy companies to raise revenues. The Labour opposition is pushing for a windfall tax. Its case has been made easier by the vast share buyback programme announced by Shell in its recent results.

If these are some of the key risks faced by the sector, the tensions in Ukraine could drive the sector higher. Russia supplies around 40% of Europe’s gas and there are fears it may hold back supply if it doesn’t receive the concessions it wants. This would probably hurt Russia as much as it would Western economies, but Vladimir Putin may consider it a price worth paying. The oil price is already 50% higher than a year ago, with gas prices seeing similar rises.

At the very least, investment in the energy sector would provide a protective hedge against escalating tensions. Rising energy prices leave Western consumers and businesses with less disposable income, so could hurt other parts of the market, particularly the consumer sectors. An investment in the energy sector could mitigate this weakness.

The actions of governments will be important. For enlightened policymakers, it may push them to accelerate the transition to alternative energy sources, thereby decreasing their reliance on capricious nations such as Russia. Others may consider the short-term pain for their citizens to be too great and row back from net zero plans.

This would seem to argue for a balanced investment in the sector. The pricing for energy transition companies is better than it has been for some time, so this may be a good entry point, but traditional fossil fuel companies may provide a better hedge against the immediate problems in Ukraine. Either way, the energy sector is likely to remain in the spotlight.