Regardless of your views on how climate change will affect the world, if it is happening, if it's something we can prevent, if it should affect government policy, it is undeniable that the issue is picking up steam as it relates to government policy, public sentiment and tax incentive structures. The Paris Climate Accords held in December of last year, though non-binding, feature goals for constricting carbon emissions and includes elements of wealth redistribution to help accomplish the goal. EPA regulatory and enforcement actions continue to pick up steam. Activists are pushing mega-pension funds such as CalPers to divest of fossil fuel investments. As suggested by a recent article by contributor Short/Long Trader, the Tesla generation buys cars more for a shared vision of fighting climate change then the actual economics and convenience of their purchases. Hard to hear the constant news reel and not take another look at your investment portfolio.
How do we react?
How should a rational investor react to these trends? The reaction entirely depends on your investment horizon and cash flow needs, but I will frame the remainder of this piece for an individual like myself who has a long investment horizon. So let's look at a few fundamentals of the world energy market.
The world runs on petroleum products in a major way. Land, sea and air transportation relies on petroleum products for cheap, energy dense, transportable (light) and residue free fuel. Natural gas powered turbines provide cheap and uninterrupted power services to residential and industrial electricity needs. Petroleum products are vital to creating things like plastics and polyester fibers and provide propane fuel for our backyard cookouts.
Clearly petroleum products and companies that provide and transport them are valuable in today's market but by their definition these products are depletable and finite. There will be a time where we simply will run out of this vital fuel source, therefore every oil and gas company is on a timeline and relies on reserve replacement to keep their entities growing or hold them steady.
There are really three deadlines to consider. One being when oil and gas reserves will simply run out, one when the petroleum depletion timeline will be forced shut by carbon emissions policies, and one when the petroleum depletion timeline will be forced shut by the development of a renewable source of energy that can provide a cheaper alternative to transport and power generation needs. To frame the carbon policy timeline, a key element of the Paris Climate accords is a shared agreement to achieve net zero emissions of greenhouse gases emitted by human activity (i.e. emissions equal levels that trees and oceans absorb naturally) sometime during the second half of the century, or 2050-2100.
This very long time horizon leads me to believe that we will either run out of commercially viable fossil fuels or develop a more promising alternative before carbon policy shuts the door on fossil fuels. The development of an alternative fuel source option appears to be the most likely in my opinion, but climate and carbon policies will likely follow closely on the success of that renewable fuel source. It's no secret that the US government will be running budget defecits for the foreseeable future and will need new revenue sources to fill the gap. A likely candidate is a future "carbon tax" or even a $10/bbl oil tax, which was recently proposed by the White House, which may accelerate the decommercialization of fossil fuels, at least in developed nations. Considering all, how is the best way to capitalize with your money?
Divest Fossil Fuels
One strategy could be to follow the Rockefellers and divest completely from fossil fuels. Given the importance of fossil fuels in today's world economy, the decision may be more emotionally motivated than economically. Fossil fuels will continue to be a vital (yet possibly shrinking) part of the world energy picture over the next 30-40 years whether you ask the EIA or Exxon (I really do suggest that you at least flip through both presentations). The downcycle in the oil and gas markets has been severe and may cause investors to forget the profits that were made on the last upcycle. If fossil fuels will continue to be a large part of our energy mix for our investment horizons, an investor who divests completely may forfeit a large opportunity to invest into an oil & gas upcycle and profit greatly. The opportunity cost of divestment drove Cornell University's decision to retain their fossil fuel investments earlier this year. An investor who chooses to completely close the door on oil & gas investments will need to have a better alternative in mind and some certainly do. Contributor Dividend Sleuth has a few ideas in mind in his two part article on defossilizing his portfolio which may be useful if you would like to achieve the same goal.
Invest In Renewable Energy Companies
Renewable energy, whether it be wind, solar, geothermal or another, is in a discovery phase not unlike the rise of personal computing technology. What was on the cutting edge a year ago may a pile of junk today. Companies must continue to evolve, adapt, and remain on the cutting edge of these technologies. In many ways, investing in the renewable energy space today is very similar to investing in biotech or tech stocks, where one new development can change everything. The feel good nature of the space paired with fast moving Wall Street pumped technology companies can be boom or bust. It can be a risky investment thesis if you are not up to date on tax policy incentives and the latest technological developments. I don't find these companies to be ideal candidates for buy and hold forever in many respects as I'd expect only a select few companies to make it. I've tried my hand at a few renewables to date with mixed results. On one hand I've been burned by the daily solar devco telenovela that is SunEdison (NYSE:SUNE), and on the other hand I've done quite nicely by the renewable financiers at Hannon Armstrong (NYSE:HASI). For someone who is attracted to the buy and hold forever model, the task of full scale investing into the renewable market as it stands today is a little more risk than I can stomach.
Invest In Oil Majors
When I think about which companies employ the greatest number of engineers, the first companies that come to mind are the Exxon's (NYSE:XOM) of the world, i.e. the oil majors. These are the companies that have driven innovation, solved technical engineering problems and managed challenging projects for years. These companies are well established and generate high levels of cash flow in all cycles due to their vertically integrated structures. In response to why Exxon has not invested in renewables, CEO Rex Tillerson has famously said that "we choose not to lose money on purpose". I translate that to "we do not believe that renewables today can compete with the returns on what we do best, so we will spend our money elsewhere". Exxon and the oil majors will participate more aggressively in the renewable energy market when technological winners and losers emerge from the startup phase and renewables are commercially viable without heavy subsidies.
The process is not unlike the development of football strategies. New formations or strategies generally develop at the high school and collegiate level and are passed upwards when they prove to be successful. NFL teams cannot afford to employ losing strategies (unless apparently you own the Atlanta Falcons), there's too much high profile money at stake. They rely on smaller programs with nothing to lose to develop new strategies, formations, and ideas and adopt the ones that work. The wildcat offense is a good example of this. Accredited to high school coach Hugh Wyatt in 1998 and adopted by programs such as Kansas State and Arkansas, it made a significant debut in the NFL nearly 10 years later and continues to be a wrinkle in NFL playbooks today. The NFL even had to amend the rule book to technically allow the wildcat offense.
My point is that the oil majors have time to take advantage of the current makeup of the world energy market and have the cash and credit worthy balances sheets to gobble up the winners in the renewable energy space when they emerge.
Picking winners out of the current renewable market can be very risky and complex start-up level balance sheets and financings such as the ones at SunEdison can become difficult to sort through. Investing in oil majors can be seen as a way to use a buy and hold approach by leverage a large cash flowing organization to indirectly capture the value of the best future renewable companies while still benefiting from the world's current energy makeup.
To use this thesis you must believe that the majors will adapt, which seems like an inherent requirement based on the limitations of producing a finite resource. They are "energy" companies in the end regardless of where that energy is sourced. The majors employ thousands of experienced project managers and engineers that will be able to refine and deliver the large scale renewable projects needed for the second half of the century. I don't anticipate this strategy will net you the 5x investment you may realize by correctly betting on an early stage solar or wind producer, but it will likely protect you from losing your capital and provide a hands off buy and hold forever platform for approaching the world's renewable future.
Invest In Utilities
The argument above can be applied to utilities as well, they will be required to adapt to the renewable market and are well placed to purchase successful renewable energy generation assets while supplying downstream customers today with cheap energy sourced from natural gas. Utilities will be forced to act by the sooner of government renewable energy mandates or raw material shortages. Shale gas has completely changed the natural gas supply landscape by providing a enormous potential for the commodity which leads me to believe that energy mandates will carry the day when it comes to utilities day of reckoning.
Utilities have an effective regional monopoly on the energy grid due to high up front capital requirements and well established infrastructure. This of course leads to the industry being highly regulated by the government, which in turn creates a give and take on the pace that renewables will develop. I think the best management teams will get ahead of the trend and begin to increase their renewable footprints. Some recent examples of this taking place today with recent renewable acquisitions by Southern Company (NYSE:SO) and Duke (NYSE:DUK). Southern recently purchased a solar field from First Solar and Duke a solar project in North Carolina.
The biggest risk to utilities are those that depart from the grid in the residential solar market. Residential solar growth will depend on continued downward trends in the cost of panels, improvement in home battery technology and continued friendly treatment by local governments. California continues to be the most friendly to the residential solar market but not everyone is on board as evident in Nevada's recent net metering rules. Even with advances in battery technology, residential solar will likely be constrained to geographically to areas with consistent sunlight year round, which makes southern California prime real estate for the space. Highly dense cities may also have trouble with large scale adaptation of solar energy where apartment buildings or other dense living spaces will restrict the ability for panel installation.
That being said, residential customers are only part of the equation, with industrial and commercial customers making up the bulk of electricity consumption. While residential customers may be able to tolerate power shortfalls when rainy or cloudy conditions restrict solar from full capacity, industrial customers are less likely to tolerate an interruptible power source that would restrict their production lines.
Though residential solar enjoys tax benefits today, I do wonder at what point in its growth cycle the regulatory bodies will pivot towards collecting tax revenues from residences off or partially off of the grid. Government spending is not going away anytime soon and lost revenues from a highly regulated utility will need to be replaced at some point if the residential solar market grows large enough.
If the world-wide transportation mix shifts significantly from ICE to electric vehicles, electric supply will also need to increase significantly to accommodate increased demand. The established electricity distribution grid and the utilities who serve it will be well poised to take advantage of a future rise of electric vehicles. Some will certainly move towards residential solar to fit their needs, but I would expect the majority of folks would still turn towards their local utility to charge up their vehicles on a daily basis.
Invest In Retail Gasoline Providers
McDonald's (NYSE:MCD) is famous for two things, one well known to all and one more behind the scenes. The Big Mac is well established in the public image, however, the scope and selection of prime real estate across the world is key to McDonald's success. Their restaurants sit on a network of high traffic, travel dense areas that are the envy of their competitors, who often drop locations around wherever a new McDonald's is built. In the same way, you see Lowe's (NYSE:LOW) and Home Depot's (NYSE:HD) consistently across the street from one another. They have identified the best locations in each area for their businesses and don't mind going toe to toe for the same customer base.
Retail gasoline providers have the same advantage. They are on every street corner that matters and often have locations on each side of the highway to conveniently serve customers driving in both directions. In summary, they own the real estate that is in the best position to serve the electric supercharging needs of a future electric transportation network. Where you see 10 gasoline and 2 diesel pumps in today's retail gasoline station, the future station may have 8 electric supercharging stations, 2 gasoline pumps and 2 diesel pumps to serve the remaining ICE vehicles.
A large number of retail gasoline locations are owned by the integrated oil majors and therefore this concept folds into the one introduced above, but there are a few large downstream non-integrated players such as Valero (NYSE:VLO) that may more responsive and nimble as first movers than the majors. A significant restriction on the electric vehicle market today a the lack of established infrastructure to serve their vehicles. Retail gasoline stations are transportation service locations in the end and the best management teams will adapt to serve a changing transportation makeup.
I have presented three ideas/trends to invest into a renewable energy future, continue to capitalize on the world's current energy makeup, and avoid taking on early stage tech selection risk. This thesis of course assumes that management teams at the oil majors, utilities, and retail gasoline providers will adapt when economically prudent and will not go the way of Blockbuster when assessing the prospects of renewables (or in Blockbuster's case, Netflix (NASDAQ:NFLX).
Not everyone will share my thesis but, in my view, the current renewable market does not provide an established buy and hold platform for a significant investment at this time. It is certain that renewables will be the future someday, but uncertainty in the timing of that someday when compared to my investment horizon gives me pause to make a large scale change today.
Annual meetings will be coming up soon and it will be interesting to see how, if any, these companies will discuss their plans towards renewables. It will be imperative to monitor corporate attitudes towards renewables in future years for signs of who will be prudent adaptors and who may be left behind.
Disclosure: I am/we are long SO, XOM, HASI.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.