My Concerns About Investing in Fossil Fuels

Oil and coal, more recently natural gas have driven the global economy for the past 200 years. As recently as 2008, coal generated half of our electricity in the UK. However we are now entering a new age for power generation in response to the global climate emergency. The transition to clean energy such as hydro, wind and solar is well underway and will be disruptive.

Due to the activities of climate protestors such as Greta Thunberg, the oil industry can no longer maintain its 'business as usual' approach. The same goes for sectors dependent on oil as well as the banks who finance their operations and also their insurers who underwrite the risks.

The Transition

The oil industry now appears to accept the science of global warming but they maintain that the demand for fossil fuels will be there for several decades and this justifies their policy to continue with exploration for new oil fields and finding new areas to drill such as the Arctic. Investors who may well be sympathetic to the climate arguments, may well agree the transition will be a long and gradual process and therefore continue with a balanced allocation which contain oil and gas stocks - now renamed as 'non-renewable' energy.

However, I would suggest the transition is moving much more quickly than the oil industry cares to acknowledge. Governments around the world are developing policies to deliver a carbon-neutral economy by 2050. To achieve this, they will need to implement policies now to have any chance of meeting their goal. Here in the UK for example, there will be no more gas central heating boilers in new properties from 2025; coal-fired power stations will be history at the same date.

In a recent announcement, the European Investment Bank says it will no longer fund fossil fuel companies after 2020 as it aligns its strategy with IPCC climate targets. The UK government is now coming under intense pressure to stop providing finance to fossil fuel developments via its UK Export Finance agency. The tap is being turned off to an industry which is preventing the world from hitting its GHG reduction targets.

Secondly, the costs of renewables have fallen dramatically in recent years. It is now cheaper to generate electricity from wind and solar compared to traditional fossil fuels or nuclear. Introduce new battery technology to even out the lack of continuity associated with limitations of renewable generation, and it's difficult to make the case for new fossil fuel generation just on cost considerations alone.

As weather patterns - heatwaves, drought, wildfires, hurricanes - become more extreme, public opinion will harden against the fossil fuel industry.

There is no doubt about the transition from the old oil-based economy to the new, clean renewable energy economy. What is not clear at present is when the tipping point is reached. After this point, the old economy will fall away very quickly.

As can be seen from the chart covering the past 5 years, the commodities and oil sector has not performed well compared to the global equities market represented by the Vanguard fund.

Global Equities v Commodities & Energy Sector

How Will Investments be Impacted

As many readers know, the investing process is cyclical - some sectors do well one year and others another year. There is a reversion to mean - equities will outperform bonds for a period and this is reversed as government bonds provide stability during periods of uncertainty. The general advice to investors is to hold a diverse mix of assets.

However, the energy transition is not cyclical but structural - its a one way process which has implications for investors because the transition will cross the tipping point which will mean changes will happen far quicker than 'experts' predict and therefore relying on past performance will carry significant risks. The billions of dollars still being ploughed into coal, oil and gas projects will become a liability to the lenders and their insurers as these have a high risk of default and a legacy of worthless stranded assets. There are many examples throughout history where new technology has disrupted the traditional way of doing things.

 

Walney Extension Cumbria
providing clean power for 1.2m homes

Of course, the smart operators will have already adapted to the changes in energy. For example, one of my recent acquisitions, Orsted has transformed itself over the past decade from oil, gas and coal business under its previous name DONG (Danish Oil & Natural Gas) to become the world leader in offshore wind. Shell are trying to take tentative steps away from the oil and gas sector and into biofuels, carbon capture and wind/solar. They have signed a 5 year deal with BSR to provide solar power for its renewables arm Shell Energy. However 98% of their global operation is focussed on traditional oil & gas so I'm not sure how easy it would be to transform a global oil major or indeed how committed they really are to clean energy. Shareholders should certainly be concerned and pushing for change.

The projection for demand for their products from the oil majors is well into the 2040s but these projections have been overly optimistic in the past. I personally suspect we are already close to peak oil and the coming decade could well see a steep decline in all forms of coal/oil extraction which we simple cannot afford to use if we are to limit global warming to 1.5C or even 2.0C as recommended by the IPCC.

Conclusion

In February, I put my multi-asset global index funds under the spotlight and was a little surprised to see the level of exposure to oil majors in my Vanguard Lifestrategy compared to the HSBC Global Strategy. Since then I have made several changes to my portfolio to reduce this exposure to fossil fuel investments.

As I re-position my portfolio towards more climate-friendly funds, I am naturally looking to filter out coal, oil and gas however, with my global index funds, this is not so easy. Even the so called ESG 'green' options all hold oil majors such as Exxon Mobil, Shell and Chevron for example. My Vanguard Lifestrategy has 25% of its equity portion invested in the FTSE All Share index which has a high exposure to the likes of Shell and BP - currently 18% - so I have repeatedly asked Vanguard UK to consider lowering the allocation to UK equities and also to introduce some climate-friendly alternatives. Nothing so far...

I remember back in 2007/08, the investing community ignored or under-appreciated the risks posed by the sub-prime mortgage crisis in the US which led to the global market crash and governments having to bail out the major banks to prevent them going under. The effects are still being worked through a decade later. My concern is this could happen on a bigger scale as investors and lenders fail to appreciate the risks associated with this global energy transition. We have  President Trump who is openly skeptical about climate change and very supportive of coal, oil and gas - he could well be in power for another 5 years.

The past 5 years have been the warmest on record and it's looking likely this trend will continue and 2019 will be the second warmest on record as the heatwave rips across Europe and the Arctic wildfires burn for weeks. Its a paradox that these past few years will most likely be the coolest of the next 50 years due to the accumulated CO2 playing out through the system.

So, I will look to further divest fossil fuels and embrace the clean energy of the future. Hopefully the likes of Vanguard and Blackrock will respond to investor demands for climate-friendly funds and I hope readers will lobby their fund managers to offer environmentally friendly alternatives. I will keep a little more cash in reserve to maybe take advantage of any sudden downturn in the markets.

Feel free to share any thoughts on the energy transition in the comments below - all opinions and views welcome as ever.