Energy: Value opportunity, or value trap?

Callum Thomas recently highlighted an observation from BAML that the market cap of Apple (AAPL) is now larger than the entire energy sector.

AAPL is now the largest stock in the index, but its weight at 4.5% is not especially extreme in the context of the historical experience. The fact that AAPL’s market cap has eclipsed the aggregate weight of the energy sector is telling.

Is this an inflection point for the energy sector? Do energy stocks represent a value opportunity that should be bought, or a value trap to be avoided?

I would like to propose a long-term bullish factor that has been ignored by the market. This factor has the potential to be the catalyst that digs these stocks out of their pariah status.

The Sun is about to undergo a period of low sunspot activity, which has shown to have a cooling effect on the Earth’s climate. The climate data that emerges over the next decade should show that the effects of human-induced warming to be partially or fully offset by the effects of the solar cycle. Public concerns about climate change, and policy surrounding a global climate emergency, are likely to abate, but that process will take time.

I conclude that while the sector is acquiring a value characteristic, sentiment is not yet a wash-out and price momentum is still a headwind for these stocks. To be sure, there is a long-term bullish catalyst waiting in the wings, but the effects of this catalyst may not be evident for several years. For now, the bull call on energy is only a trade set-up. I am inclined to wait for signs of a technical turn before turning significantly bullish on the sector.

The new tobacco?

In this era of hyper-sensitivity about climate change, energy stocks are being shunned in a way that they are becoming the new tobacco stocks. The topic has grabbed the attention of top policy makers and major investors. Canada’s Financial Post reported that BoE Governor Mark Carney warned financial services companies need to take action to cut CO2 emissions:

Financial services have been too slow to cut investment in fossil fuels, a delay that could lead to a sharp increase in global temperatures, Bank of England Governor Mark Carney said in an interview broadcast on Monday.

His remarks painted a big cross-hair on the energy sector.

Carney cited pension fund analysis that showed the policies of companies pointed to global warming of 3.7 to 3.8 degrees Celsius, compared with the 1.5-degree target outlined in the Paris Agreement on climate change.

“The concern is whether we will spend another decade doing worthy things but not enough… and we will blow through the 1.5C mark very quickly,” Carney said in a radio program guest edited by teenage environmental campaigner Greta Thunberg.

“As a consequence, the climate will stabilize at the much higher level.”

The Economist reported that Jeremy Grantham of GMO echoed Carney’s assessment.

Late last year Jeremy Grantham, an investor routinely described as “legendary”, spoke about esg (environmental, social and governance) investing at a conference in London. His presentation was slick; his accent floated somewhere in the mid-Atlantic (Mr Grantham is English but has lived in America for ages). “I love s and g,” he began. “But e is about survival.”

As a consequence, Grantham is uber-bearish on oil stocks, to the extent that he believes investors need to make the oil industry a pariah.

Is there also a moral case for disinvestment? An argument against is that oil firms are best placed to speed the transition to solar and wind power. They have experience of managing big projects in difficult terrain. And many would say that dumping oil stocks is a pointless salve to the eco-warrior’s conscience. Bill Gates, a software mogul and philanthropist, has argued that people should not waste idealism and energy on a policy that will not cause any reduction in the use of fossil fuels. What matters are incentives set by governments: tax breaks to fund research in green energy; tax rises to discourage carbon use. But this misses the point, says Mr Grantham: “You have to make the oil industry a pariah for bad behaviour.” Only then will politicians feel the need to act.

BlackRock CEO Larry Fink released a letter to CEOs to assert, “Climate change has become a defining factor in companies’ long-term prospects.” It is time for fiduciaries like Blackrock to act.

Over the 40 years of my career in finance, I have witnessed a number of financial crises and challenges – the inflation spikes of the 1970s and early 1980s, the Asian currency crisis in 1997, the dot-com bubble, and the global financial crisis. Even when these episodes lasted for many years, they were all, in the broad scheme of things, short-term in nature. Climate change is different. Even if only a fraction of the projected impacts is realized, this is a much more structural, long-term crisis. Companies, investors, and governments must prepare for a significant reallocation of capital.

While Fink did not come out and say it, his term, “a significant reallocation of capital” is code for divestment to force up the cost of capital of companies that contribute to climate change and global warming. As BlackRock’s assets under management total about $7 trillion, this statement will bound to have a chilling effect on the energy sector.

Cheap enough?

Are energy stocks sufficiently washed out? Investors have been shunning energy stocks for over a decade. The sector has undergone over 10 years of poor relative returns.

Is their valuation cheap enough? FactSet reports that the energy sector trades at a forward P/E ratio of 17.5, which is well below its 5-year average of 29.1 and 10-year average of 20.4. Before anyone writes me to complain that oil and gas stocks trade on cash flow multiples, I would point out that, on a cap weighted basis, the US energy sector is dominated by integrated companies with substantial downstream refining and marketing assets. In such instances, the use of a P/E multiple to value integrated stocks is entirely appropriate.

Moreover, the most liquid energy sector ETF,XLE has a dividend yield of 3.7%, compared to 1.7% for the market, as represented by SPY.

A long-term bullish factor

There is no doubt that energy stocks are cheap, but cheap stocks can become cheaper in the absence of a bullish catalyst, especially if investors perceive them to be in an industry in decline. However, I would like to propose a long-term bullish factor that has been ignored by the market. This factor has the potential to be the catalyst that digs these stocks out of their pariah status.

Cosmic rays.

An important article at Electroverse explains how cosmic rays (CR) and the solar cycle affect the Earth’s climate.

During solar minimums –the low point of the 11-or-so-year solar cycle– the sun’s magnetic field weakens and the outward pressure of the solar wind decreases. This allows more cosmic rays to penetrate the inner solar system as well as our planet’s atmosphere:

The solar cycle has a regular ebb and flood pattern of 11 years. The Sun is about to undergo a period of low sunspot activity. The level of cosmic ray radiation is inversely correlated with the level of sunspot activity, which affect the Earth’s climate.

More crucially however, CRs hitting Earth’s atmosphere have been found to seed clouds (Svensmark et al), and cloud cover plays perhaps the most crucial role in our planet’s short-term climate change.

“Clouds are the Earth’s sunshade,” writes Dr. Roy Spencer, “and if cloud cover changes for any reason, you have global warming — or global cooling.”

The upshot of this current solar minimum (24) –the sun’s deepest of the past 100+ years (NASA)– is a cooling of the planet, with the coming solar cycle (25) forecast by NASA to be “the weakest of the past 200 years“:

In fact, the forecast calls for a prolonged period of low sunspot (high cosmic ray) cycle that is reminiscent of the Maunder Minimum. Studies by NASA have attributed low sunspot activity to be the cause of prolonged cooling periods like the Maunder Minimum, otherwise known as the Little Ice Age of the 17th Century. For some perspective, here is a painting by Hendrick Avercamp entitled “A Scene on the Ice” documenting life in Holland during that period (see link for source).

Subsequent to the Little Ice Age, the Earth experienced another one of the Sun’s extended periods of low sunspot activity called the Dalton Minimum. This particular minimum lasted from about 1795 to the 1820s. The year 1816 was in the middle of the Dalton Minimum period. It is still known to historians as the “year without a summer”, the “poverty year”, or “eighteen hundred and froze to death”. Poor conditions were said to have been caused by a combination of a historic low in solar activity and the Mount Tambora eruption of 1815, which spewed extensive amounts of volcanic ash around the world.

It was a time of ecological disaster. 1816 saw snow in June in the U.S. and Europe. Crops failed and starvation followed, many Europeans spent their summers huddled around the fire. It was during this bleak summer that Mary Shelley was inspired to write Frankenstein and John William Polidori, The Vampyre.

The Electroverse article continued:

Solar cycle 25 is predicted to be a mere stop-off in the suns descent into its next full-blown GRAND solar minimum cycle. (GSM).

NASA has linked GSM episodes to prolonged periods of global cooling, like the Maunder Minimum. or Little Ice Age.

Viewed in this context, Anthropogenic (human caused) Global Warming, or AGW, is a blessing in disguise that offsets the effects of the cooling effects of the solar cycle. The magnitude of the cooling observed during that era dwarves the worst case scenario of climate activists. These offsetting factors would represent good news for the human race for the rest of this century.

Investment implications

What does this mean for investors?

NASA’s models for the current solar cycle, which lasts 11 years, calls for the Earth to undergo a cooling period from rising cosmic ray radiation. The models calling for a Grand Solar Minimum cycle are more speculative.

Nevertheless, the climate data that emerges over the next decade should show that the effects of AGW to be partially or fully offset by the effects of solar cycle 25. Public concerns about climate change, and policy surrounding a global climate emergency, is likely to abate, but that process will take time.

While this development is bullish for energy stocks (and agricultural commodities) in the long run, it does nothing for the energy sector over the next one or two years. The effects of the solar cycle represents only a trade setup, and not a full-blown buy signal. While political pressures are rising for solutions to climate change and global warming, the market reaction to these pressures is only beginning. As an example, CNBC reported that Microsoft aims to become carbon neutral by 2030, and eliminate its historical carbon footprint by 2050. Amazon has pledge to be “net carbon neutral” by 2040. These calls to action are reminiscent of the atmosphere during the dot-com era of the late 1990’s, when even mining companies would not dare to present to investors without a “broadband strategy”.

ESG investing is still a nascent theme. At only 2% of the market, it has much more room to expand, especially in light of Larry Fink’s call to action.

Looking over the next 12-24 months, the BAML Global Fund Manager Survey shows that while managers are underweight the sector, they have not been in such a prolonged underweight position that these stocks are hated. We have not seen the classic signs of investor capitulation and wash-out yet.

From a trader’s perspective, both US and European energy stocks remain in relative downtrends, punctuated by a brief spike owing to Iranian tensions. Until the relative downtrend shows some signs that it is ending, an underweight position remains tactically warranted.

I began this article with the rhetorical question of whether energy stocks represent a value opportunity, or a value trap. While the sector is acquiring a value characteristic, sentiment is not yet washed-out, and price momentum is still a headwind for these stocks. To be sure, there is a long-term bullish catalyst waiting in the wings, but the effects of this catalyst may not be evident for several years. For now, the bull call on energy is only a trade setup. I am inclined to wait for signs of a technical turn before turning significantly bullish on the sector.