Crude Oil and Alt Energy: The Non-Relationship That Won't Go Away

The relationship - or lack thereof - between oil prices and the performance of alt energy stocks has been a long-time interest of mine. I discussed it last in late March when I looked at correlations between the daily returns of alt energy and fossil energy ETFs. At the time, I found that only a weak relationship existed between the two and that if someone wanted to make a thematic investment play on Peak Oil, alt energy ETFs were not an ideal way to do so.

Seeing as the popular press and countless "experts" continue to claim, whenever they get a chance, that the fortunes of alternative energy stocks are closely tied to the price of oil, I figured I would revisit the topic.

Fossil & Alternative Energy: The Relationship That Isn't There

This time around, I took a slightly different approach for my analysis: I correlated the weekly returns for US oil and US natural gas directly (as opposed to through an ETF) with returns for the S&P 500 and four alt energy ETFs. For US Oil and Nat Gas, I used price data provided by the Energy Information Administration here (Spot Price FOB Weighted by Estimated Export Volume) and here (Contract 1), respectively. I got ETF and S&P 500 price and index value data from Google Finance.

For the ETFs, I picked the Claymore/Mac Global Solar Index ETF (TAN) as the solar sector representative, because I took a position in it in March (which I liquidated last week even though I initially claimed I would hang on to it for 18 to 24 months. I have now grown more worried about downside risk than I am optimistic about upside prospects over that time horizon, so I took my money out).

The other ETFs were: the First Trust Global Wind Energy Index (FAN) for wind, because it represents a more direct play on the sector than the alternative; the PowerShares Clean Energy (PBW) ETF for alt energy other than solar and wind, as an analysis I conducted earlier this year indicated it is the best way to access other sectors; and the Powershares Global Progressive Transport (PTRP) ETF, as it provides the only proxy I know of for returns on a basket of stocks with exposure to alternative modes of transportation.

The graph below displays returns for all four ETFs, Oil, Nat Gas and the S&P 500 between Jan. 1, 2007 and Sep. 25, 2009 (click on the image for a large view).



The table below shows returns and volatility for all seven assets over the same time interval but broken down into sub-periods. Seeing as 2009 and the post-Lehman collapse period have been eventful times to say the least, I thought it would make sense to create a few distinct sub-periods for analytical purposes.

What jumped out at me from this table is the relatively strong performance of the Powershares Global Progressive Transport (PTRP) ETF, even after adjusting for volatility. As the correlation analysis below demonstrates, this performance is not due to a rise in oil prices.

My going theory is that there is a Green Stimulus Effect at work given how much of global stimulus dollars have gone to transportation programs. This would be something worth exploring further but it certainly seems in line, at least on the surface, with a prediction I made nearly one year ago.



The following three tables contain the real meat of my analysis. They are fairly self-explanatory: they show correlation coefficients between US Oil, US Nat Gas and the S&P 500 with all other assets. The correlations are for the periods outlined in the tables or since inception in the case of PTRP (Sep. 19, 2008), TAN (Apr. 18, 2008) and FAN (Jun. 20, 2008). The correlation coefficients above 0.5 are highlighted.




These results are, once again, in line with my expectations: there is little reason to believe that there is a strong relationship between changes in the price of oil and the performance of alt energy stocks. Even for natural gas, where one could expect a correlation with wind and solar given that all three fuels are used in power generation (or load abatement), there does not seem to be a strong relationship.

TAN and FAN have not yet been around for long enough to analyze returns going very far into the past, but PBW has. Although the correlation between PBW's returns and oil's returns seems to have strengthened somewhat in the past year, it certainly does not qualify as strong.

I must admit I was fairly surprised to find such a low correlation between the returns on oil and those on the PTRP ETF. My guess is that this ETF hasn't been around long enough, and that a relationship might emerge under an extreme Peak Oil scenario. That said, spending on public transportation is heavily dependent on the fiscal health of various levels of government, and we've just been moved from the emergency room to the critical care unit.

On the other hand, I was not particularly surprised to see that returns for all four alt energy ETFs are correlated with returns for the S&P 500 - that seems intuitive enough given that they all belong to the same asset class.

Conclusion

It doesn't really matter how one slices and dices the data: there just does not appear to be a strong relationship between returns on oil and returns on alt energy stocks, including alternative modes of transportation.

That's not going to matter to a great many commentators who will continue to claim in newspaper and magazine articles, on blogs and on TV that the success of alt energy stocks is closely tied to the price of crude, even though that's mostly untrue.

Those who invest in alt energy should, however, pay close attention. These results suggest that there are far more important factors than oil prices, most notably returns in equity markets in general and regulatory incentives by governments.

There is a good chance that equity returns and returns on oil will diverge in the next couple of years as oil prices climb and equities stagnate or decline. If such a scenario materializes, those who have the relationship backwards could be in for unpleasant surprises.

DISCLOSURE: None

Comments

[jerrydd:]

I think supply and demand explains this. Oil will go up with a bullet as soon as the world economy recovers, hitting $150bbl+ in Dec 2010, more or less. Why is we peaked in oil product last yr. It's not fiscally possible to pump more with damaging the wells. Mexico soon will be an importer of oil. North Sea fields will be mostly gone by 2020, most others like Alaska which use to pump 2Mbbl's/day now down to under 800kbbls/day. New finds are far below under 1bbl found for 3+bbls used.

Electricity though can be made from many sources so the lower costs ones drive the cost, through competition, keep costs inline.

Sadly for investors, most RE is in home sizes where the only investment might be special loan securities to pay for this equipment or in a company that makes this equipment but there are few. One I like is a start up with it's waste heat engine. Nothing that shattering, just a good combo of advanced steam engine tech and modern materials. Why more companies don't make regular and low temp Steam, Rankine or other heat engine.
Cyclone Power, cyclonepower.com

Sorry I'm just excite finally one engine of this type will be available. Others like A/C companies because an A/C is just a heat pump, in reverse would be an eff heat engine making power if fed by any heat source over 400F or even lower at lower eff.

A home would need just a 5kp, 3.5kw engine, a 200sq' trough solar collector, an alternator to supply all the power and heat an eff home would need. Double size collector in northern areas for winter use. And can be fired by wood pellets or any fuel if needed. About $6-8k or $2-3/kw

A 2kw wind generator is just an alternator, a pole, tail, 3 blades so just not expensive to produce.

. One can produce in many locations the power needs of an eff house or 2units could heat it too. Under $2k/kw. Coal is $4k/kw to build plus fuel handling, costs.


Already for solar farms for $1/wt, PV panels at $2/wt retail marketed with panel, inverter, mounting package that you just fold out and plug and play. Watch for solar companies doing this and buy in early.


So how does this effect oil, because in 10 yrs many cars will be EV's, PHEV's or subcars, lightweight 1-2 passenger EV, iCE powered and most trucks, semi's will be NG fueled. This will compete so well with for less than they pay now, have their own energy production for both home and EVs.

NG looks plentiful so price will unlikely hit above $10/mmbtu or about 7gals of oil equivalent. Even at that price, far above extraction costs should make it a favorite future fuel.

All the tech needed is already known to compete with oil, we just need to build, use it.

And there is no lack of energy, just the equipment to catch, make and use it. So bet on oil in the 2-7 yr but after that, the party is over as the price of oil, $10/gal in 5 yrs, will force becoming independent of it..

Oct 08 08:17 AM

[Dave Marsh:]

Thanks for reiterating something that makes me cringe on a regular basis. Since the U.S. generates less than 1% of its electric power from oil (only old peaker units), and there is essentially zero use of grid power in electric cars at this point, there simply cannot be a real correlation between solar/wind economics and oil price. Alternative electric power competes with grid price of electricity, and only widespread adoption of electric cars would link the two (grid electric price and oil transportation cost). I've tried emailing CNBC to educate them on this, but few get it. Occasionally you will hear "Well the correlation is largely psychological" from someone regarding say, oil price and solar stocks, but for the most part the media perpetuates the myth, every time.

Oct 08 09:07 AM

[Steve in Gr...:]

Great article Mr. Morand. I think you hit the nail on the head when you wrote "...there are far more important factors than oil prices, most notably returns in equity markets in general and regulatory incentives by governments..."

Natural gas is used to generate electric power. According to Wikipedia (Electricity Generation), it accounted for 20% of U.S. electrical power in 2006. So why isn't it correlated with alternative energy equities?

As you wrote, the primary value proposition in alternative energy is not economics but rather collecting government subsidies. Alternative energy equities are positively correlated with the willingness and ability of the U.S. government to subsidize it.

Oct 08 11:07 AM

[Franck Pris...:]

Dave, spot on. I too have emailed CNBC several times, and written a lengthy paragraph on the subject in my book "Anatomy of the Meltdown - 1998-2008."

However, this is not to say we can't make money investing in Alternative Energy and Infrastructure, regardless of where the price of oil and nat gas go. In 2005, I launched a plain vanilla fund for a French bank, and we eaked out a 13% outperformance vs. the MSCI Global as of June 2009. In addition, we had a beta of 1, which was the differentiating objective with the ETFs that Charles mentions.

On LinkedIn, I created a group called "Investing in Renewable Energy - Do's and Dont's", should you guys be interested.

Charles, thanks for your post. Hype is what kills the Golden Goose.


On Oct 08 09:07 AM Dave Marsh wrote:

> Thanks for reiterating something that makes me cringe on a regular
> basis. Since the U.S. generates less than 1% of its electric power
> from oil (only old peaker units), and there is essentially zero use
> of grid power in electric cars at this point, there simply cannot
> be a real correlation between solar/wind economics and oil price.
> Alternative electric power competes with grid price of electricity,
> and only widespread adoption of electric cars would link the two
> (grid electric price and oil transportation cost). I've tried emailing
> CNBC to educate them on this, but few get it. Occasionally you will
> hear "Well the correlation is largely psychological" from someone
> regarding say, oil price and solar stocks, but for the most part
> the media perpetuates the myth, every time.

Oct 08 12:12 PM

[Franck Pris...:]

Most of what needed to be said was said on this thread. I will add a couple of things.

Charles, you may want to check this, but from 2005 to the end of 2007, the R2 between Solar stocks and Oil was around 0.95. It did not make sense, for the reasons already given. My only explanation was, at the time, a link with the Chinese stock market. Solar companies being Chinese for the most part, I figured they were riding that spike. Then, the correlation disapeared in 2008, in particular as Oil went to $140 / bbl. They did not participate, except on the subsequent downside - when every went to pots anyway.

It also disapeared in 2006, after the collapse of the European Carbon Credit markets and the descent to hell of ethanol producers - PBW never participated in the year-end rally.

I think one element to consider is the high beta of these ETFs - I call them sticks of dynamite. They cannot attract long term institutional money - and who wants to speculate these days.

Another thing is that they are pure plays or pure green, for the most part. Most will exclude Nuclear and E&C companies with "dirty" legacy business. And most will exclude companies which do not derive a significant part of their revenues for RE et al. This is a fundamental flaw. The fact is, there are very few technical breakthroughs and most companies are bleeding edge - take a look at the shareholders equity of the fuel cell companies, for example, and you'll see how much money they have spent overtime for essentially no commercial results.

So they are in constant capital raise mode - not exactly at the right time these days. However, if one looks at some bigger plays, they have the R&D budgets - even if they can use more from Uncle Sam. Example: I have owned Maxwell for a long time, as I believe they are down the right path (I recently sold some, and I can't wait to get back in). The alternative was to own Johnson Controls or Saft, with whom they have a JV.

That's were it becomes tricky - when you buy a smaller guy, they are usually in one business, and you take that specific risk. When you buy a larger guy, you usually buy the rest of their business. Anybody who buys Wells Fargo because it is the greener bank in the US better look at their banking business first...

Lastly, I agree with the comment about subsidies - not the right time either. However, there is another angle to subsidies, and that is job creation. A good site to look at is REPP.org: 200 Gigawatts, $200Bn, 1Mn jobs. This why ethanol was so popular, in time for the 2006 mid-term elections - only to cost $7bn per year and some $5bn in vanishing market caps. I have long said, if we want subsidies for job creation, let's say so. If we claim subsidies are for the advancement of R&D, let's allocate according to technological merits. Which brings to Climate Change, but this is another story...

Oct 08 12:42 PM

[netboyz:]

The comment above makes sense to me, that little electricity is generated by oil so correlation between RE and oil would be low. I wonder if there is closer correlation to coal, although the lack of correlation to NG makes me doubt that too. It would be interesting to see coal added to the tables.

Is this analysis pretty much showing that cost of renewable-sourced energy, even with current subsidy levels, isn't sufficiently close yet to coal/NG-sourced energy to enable widespread cost-based substitution? And that the investment market does not yet see when that will occur?

Oct 08 02:24 PM