Energy markets: the right opportunity at the right time

Commodity markets are subject to a myriad of different forces. It is important not to make assumptions anchored on historical norms, says Mark Hume, Co-Portfolio Manager of the BlackRock Energy and Resources Income Trust plc.

Capital at risk. The value of investments and the income from them can fall as well as rise and are not guaranteed. Investors may not get back the amount originally invested.

The recent surge in natural gas prices has created chaos: from disruption in UK meat supplies, to higher electricity prices, to rising travel costs. For investors, it is also a reminder that there are multiple drivers for energy markets and multiple industries that depend on them. To our mind, this argues for a flexible approach.

There has been a significant focus on climate change and the need to decarbonise industries. The energy transition has three powerful elements creating long-term momentum – regulation, society and economics. On regulation, we believe it is likely to tighten faster than many have predicted as governments across the world strive to achieve ambitious net zero goals.

Growth in renewables

Societal expectations are also driving change. People are increasingly making consumer choices based on carbon impact and there is real pressure on policymakers and business leaders to bring about change. Eventually, however, it will come down to economics. We believe technology will drive down the cost of renewables to increasingly competitive levels. For example, we see the amount of installed wind power likely to double between 2020 and 2030, which will create huge economies of scale.

In this way, the growth trajectory of renewables – plus associated areas such as energy efficiency and clean transportation - seems assured. The question is where this leaves more traditional forms of energy. By rights, in this powerful move to renewables, prices shouldn’t be rising for natural gas or oil, but the reality is more complex.

As investors, we need to be flexible and alert to these changes.

‘Legacy’ commodities

It takes time to make the switch to renewables. The recent spike in natural gas prices was a result of increased demand and tight supply. An extended cold period across the northern hemisphere earlier this year meant less gas was stored in summer than normal, leaving less supply to meet winter demand. Prices could rise even higher from here unless supply comes on stream1.

In the oil markets, it is also possible that demand could substantially outstrip supply in the short term. Companies are generally not investing in new oil supply, preferring to focus investment on alternative energies – discipline is now a reality, with US producers reinvesting just 50-55% of underlying cashflow year-to-date compared with prior decade highs of over 150%. Equally, equity and debt markets are no longer willing to support investment in new supply. In previous periods of high oil prices, supply has been brought on stream to help meet demand. This time, prices could simply spike higher.

From an investment point of view, this creates opportunities. The legacy energy companies have been unpopular and generally trade cheaply to their peers. These companies also have a place in the energy transition, with many of them important investors in renewable fuels and infrastructure.

Mixed picture in mining

It is a similar picture in the mining sector, where investors need to be nuanced about the fortunes of individual commodities. For example, iron ore demand looked set to benefit from the vast global infrastructure boom, but has recently seen prices fall because of falling demand from China - a timely reminder that analysing the current baseload demand is as important as understanding the sources of future demand growth. It is vitally important to retain flexibility as the market changes.

That said, the sector as a whole is very different to previous cycles, which have tended to end with over-supply as companies embark on spending binges. This time round, we see significant capital discipline in the mining sector, with a rock-solid commitment not to repeat past mistakes. This is helping ensure that the companies are delivering record dividends and cash flows. In general, the sector is in good health.  

The move to decarbonise the global economy is a vast, multi-layered change. The fortunes of the various participants – and the commodities on which they rely – will ebb and flow. As investors, we need to be flexible and alert to these changes. In the longer term, we expect that more and more of our portfolio will be in post-transition companies, but in the meantime, we continue to look across the energy complex to find the right opportunity at the right time.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or financial product or to adopt any investment strategy. The opinions expressed are as of October 2021 and may change as subsequent conditions vary.

1CNBC, Sep 2021