Lead, Follow, or Get Out of the Way

Through history, leadership is enduring. Great leaders are always great leaders. But markets are different; leadership changes with regularity. What leads markets on the way up, typically leads on the way down too, but it doesn’t lead the next leg up. A common mistake investors make is to become married to old investment themes and fail to respond to the leadership changes that follow. Markets reflect constantly changing economic realities. This can easily be seen in the chart below. As economies evolve, leading companies come and go with regularity. Very few companies stay on this list for multiple decades.

Source: Open Field Capital

When Covid hit, and we were all sequestered, we used technology to help us function and the companies that provided those services skyrocketed as demand soared. Zoom Video (ZM), which allowed us to have easy video communications during the pandemic, is a perfect example. Zoom rocketed from the high $60’s before the pandemic to a high of almost $590 in late 2020. This week, after a recent rally, the stock closed at $112. If you owned the stock the entire time, you’ve still done very well (and much better than many other examples), but if you bought a little bit late, you’re probably underwater. Zoom is a terrific service and we still use it frequently here at Palumbo Wealth Management, but the economic situation has changed. Covid mutated into lesser strains; we developed vaccines and therapeutics; and the demand for Zoom was also altered. The market leader of one time frame often becomes the loser of the subsequent time frame. The lesson is that we should never get married to a single strategy, no matter how good the long-term outlook might appear.

Likewise, the energy sector had been unloved for years on the basis of a green future and a presumed decline in fossil fuel demand. Then the oil demand shock from the pandemic took oil futures prices into negative territory in the spring of 2020. It appeared to be curtains for the traditional energy sector, but that never happened. Energy/fossil fuels have been the single big winner in 2022. The charts below show the various S&P 500 sector ETF performance for 2020-21 and for 2022 YTD. Note the two worst performing sectors in 2020-21 are not only the best in 2022, but they are the only sectors showing positive returns!

When it comes to markets, the first shall be last and the last shall be first…

Why are Energy Returns so High?

There are many reasons:

Economic Growth (more growth = more energy demand)
Underinvestment (underinvestment = less oil and gas discovery)
ESG pressure (lack of investment interest = higher cost of capital for energy companies)
Silly Policies (Euro reliance on a political adversary for majority of energy supplies)
A conflict in Ukraine (and a boycott of Russia, a very large producer)

Add those up and you have a perfect storm for higher oil and natural gas prices because there are very few possibilities to offset these items.

Lifting sanctions on Iran could increase production, but that raises other serious issues
Venezuelan oil infrastructure is a mess and unable to increase production in a meaningful way
Saudi Arabia and the UAE could conceivably increase production, but the Saudi Prince is in no mood to help President Biden, who called him a pariah because of the Khashoggi killing
We appear to be unwilling to ask the US oil and gas industry to help

Of all the items above, the most meaningful is the underinvestment in traditional energy. After the last peak in oil prices in 2014, upstream (exploration and production) investment declined sharply and has remained at low levels (see chart below). The current high prices are beginning to reverse that trend, but it takes years to find, produce, and bring new energy supplies to market. Energy is not a spigot that can be turned on and off at will.

What about Green Energy?

Green energy isn’t dead, but neither are fossil fuels. It is important to understand that despite the very rapid growth of green energy, global demand for oil and gas is still growing. If we want oil prices to come down, we need to accept that oil and gas is still a necessary commodity and will be for a very long time. Rather than hold back investment in oil and gas, we should be encouraging investment to not only produce the required energy, but to do so in a way that also reduces CO2 and methane emissions.

Is the Energy Party Over?

ESG investment, which has been primarily greenwashing, recently had its first funds outflow; finally beginning to respond to the incredible performance of the energy sector this year. That’s a trend we suspect has some legs. A flight from ESG investing should produce continuing demand for oil and gas stocks.

It may seem hard to believe, but it was less than 8 years ago that the energy sector was about 10% of the S&P 500 market capitalization. At the low in 2020, energy was only 2% of the index. Now, despite the massive energy rally this year and the declines in other sectors, energy has only recovered to about 4% of the S&P 500 index. Despite a massive move higher thus far in 2022, the fossil fuel market appears supply constrained and energy stocks probably have more room to run.