Ten hot energy stocks to buy now

What is the future of energy, and where are the best investments to be found? John Stepek talks to MoneyWeek's panel of experts, who tip the ten best energy stocks to buy now.

John Stepek talks to our panel of experts about the future of energy, and where the best investments are to be found.

John Stepek: How much are today's high oil prices due to oil supplies peaking?

Richard Hulf: Academic work talks of a gradual build-up to peak oil and gas production, then a long, choppy plateau. It seems as if there will always be some new complex field, some sub-salt Brazilian play that will come online, just when you thought Saudi Arabia was going to fall off a cliff. There seem to be adequate untapped supplies to keep us going at least until 2013-2016. So we're more focused on demand from the emerging economies of India, China and South America, as being the main driver behind the oil price.

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Alastair Bishop: But it's fair to say that peak cheap oil might have happened. All these sources have increasingly high extraction costs. That means higher prices, when combined with the demand picture.

John: What if China slows down?

Alastair: Oil is still connected to the economic cycle, so if we go into a double-dip, prices will fall. But structurally, things look like they are tightening. Over the next few of years, that doesn't look like it'll change. And if you look at the last 20 years, most of the incremental demand has been met by non-Opec supply, particularly Russia. But this supply doesn't seem to be growing. That shifts the burden back to oil cartel Opec, and there are question marks about how much supply they have, particularly with Libya being out. That increases the risk of a supply shock.

Alastair-Bishop-50x70

Edward Guinness: There are also few signs of significant demand destruction. In the US, they still pay a lot less than we do for petrol. So arguably, the US could endure a much higher price without hitting demand too much. If the Middle Eastern unrest fades and Libya comes back on stream, that could hit prices. And in the longer run, a rise in Iraqi production might give us a more balanced supply-demand picture. But even then, there is a floor built in because of Opec's leverage. They are not going to defend the oil price at $100, but they probably will at $75-$80.

John: If expensive oil is here to stay, then what's the most promising alternative?

Alastair: Oil is mainly used for transport. So in terms of direct substitution, you are looking at moving to compressed natural gas, which the US is starting to consider. Or there's the electrification of transportation, which is more of a power generation story.

Edward: You have to think in terms of a portfolio, rather than the idea that one technology will change everything. With renewables, various technologies are at various stages. Wind is, broadly speaking, competitive on a price-per-kilowatt-hour basis with rival technologies, although it could do with US natural gas prices rising to support higher electricity prices. Solar has come down dramatically it probably needs to fall another 50% for people to start grasping how big solar could be. As for the marine technologies, they seem a long way away from anywhere meaningful for investors. And hydro in the developed world is reasonably well built up there's not much more we can do.

Alastair: The other important part of the solution is energy efficiency. In many cases, it doesn't require subsidies, has short payback periods, and saves people money, so it ticks a lot of boxes.

John: I suppose the big question is: will an energy shortage drive us all back to the Stone Age, or can we get over this without our standard of living falling too far?

Alastair: A recent report by McKinsey estimated the US could cut total energy consumption by almost a quarter, purely by implementing energy efficiency technologies that would save money in the longer run: things like better fridges, better lighting, better air conditioning

John: Painless changes?

Alastair: Over the life cycle. The problem is they have an upfront cost, so you need the support in place, or at least the legislation to drive that change.

Edward: A lot of efficiency wins are easy wins, which is why we should focus on them right now. But if you think longer term, 25 or 30 years, I hope that as a world we will be using considerably more energy than we expect to today. The idea of a 40% rise in energy usage in 20 years seems a huge underestimate. Energy is so intrinsic to improving quality of life that we'll need to use far more. It's not as if the price of alternative technologies is ten times that of existing ones. For solar, it's maybe twice the price it needs to be. So I believe, with time, we will have a good portfolio of technologies at a low enough cost that we won't worry about being constrained by the supply of fossil fuels.

Richard: Just now you've got 20% of the population people like us using 50% of the energy. It's hard for us to say, "There's no scope for anyone else to improve their standard of living".

John: Isn't China spending a lot on green projects?

Alastair: They need to. Over the last ten years, their share of world energy has doubled, so they are now the largest consumer of energy. But on a per capita basis they are at less than a quarter of the US level. So that's only going one way, which is why China's energy policy is so critical. The number of cars per 1,000 people in the US is about 700 in China it is 40. They are going to catch up. They may be more efficient cars, but there are definitely going to be more cars in China. So energy usage is going to grow.

Steve Main: If we are looking at vehicles, the efficiencies can be brought in through the body shells. SGL Carbon, for example, is working with BMW to develop carbon shells which reduce the weight drastically and so also lowers the power drain on the battery or engine or whatever it may be.

John: Do you think the Fukushima disaster has set nuclear back a long way?

Alastair: It's very clear that Germany is moving away from nuclear, whereas the UK and the US have stuck with their plans for more. But the International Energy Agency (IEA) recently suggested that the extra capacity added over the next 20 to 25 years would be half what they thought prior to Fukushima. It's also had an impact on old capacity. A quarter of the world's capacity was built before 1980, which was the cut-off point that Germany used for the reactors it wanted shut down immediately.

Edward: Also there will be increased regulation. So what should have been a good interim technology for the next 50 to 60 years will be a much smaller part of the equation. I think natural gas will fill the biggest part of that gap in the near term. That will push natural gas prices up, which will push electricity prices up, which will eventually effectively finance the shift to other forms of technology.

John: Will Germany's scrapping of nuclear help the renewables sector?

Alastair: If you are going to shut all your nukes off by 2022, something has to fill the gap Germany is focusing on offshore wind. But you need a lot of investment in the infrastructure. Offshore wind is at the north of Germany; most of the power is needed in the south. So you have to improve the power grids to make it work.

Richard: On that point, in the long run, generating electricity centrally doesn't make sense there are huge losses when you redistribute the energy out to towns and cities. A mechanical engineer I work with suggested that eventually we'll be able to miniaturise most of the generation capacity, so that individual houses will generate electricity themselves, perhaps even recharging their own electric cars. But that is way in the future.

Steve: In the very short term you almost have an attempt at that right now with solar cells on people's roofs and wind turbines, but it's nowhere near enough to provide a whole electricity supply.

Richard: Yeah, turn on the kettle and you've used up a whole year's worth.

John: On natural gas, do you think environmental concerns about fracking will be a problem?

Steve: From what I understand there have been very few cases of groundwater contamination. The main issue has been recycling the chemical solution used in fracking. It's either been sold to government water boards which process it for them, or to cowboys who have been dumping it illegally. That's where a lot of the pollution has come from. If they can control that, I don't think it will be a problem.

Richard: The reason we are still cautious on shale gas is nothing to do with contamination it's the physics. With shale, you get very high initial rates of extraction, then it drops off quite quickly. It's not until you have spent a few years on a number of different fields in a particular basin that you begin to understand whether it is really working. They have got it working in parts of the US, but it's taken them 20 years. They are talking about doing the same in Poland and other places, but it will take a long time. So we are sitting on the fence.

Edward: Yes, working out the marginal cost of shale gas is incredibly difficult. Because of these rapidly declining rates, you don't know whether long-term production will be at 50% or 5% of your original rate. And that's what sets the marginal cost, because it's such a big capital expenditure upfront. We think the marginal cost is higher than the current natural gas price in the US. For now, the scale of the reserves is keeping the price down, but once the true economics come through, a higher price is inevitable.

Steve: Yes, you hear stories of smaller players continuing to produce from wells that aren't commercially viable because it would cost them $10,000 to plug them. So they take a short-term loss and hope the gas price will rise and return them to profitability. It's a very difficult industry.

John: Where are you investing just now?

Edward: One area which has the weakest investor sentiment, and some of the lowest valuations, is solar. It's hard to find a sector where American hedge funds want to be more short.

John: Explain the industry for us.

Edward: It's a very challenging investment area. There is a particularly long value chain. At one end there are companies that make polysilicon, which is an energy-intensive process that takes a raw material worth $2 a kilo and turns it into high-purity polysilicon that is now sold for $45-$50 a kilo. The polysilicon is then formed into ingots, then sliced into wafers. These are treated, so that a wafer becomes a cell with photovoltaic properties. Module manufacturers then take the cells and combine them into modules with aluminium frames and wires attached. After that, in the value chain, there are distributors, installers, and then investors who fund the specific projects.

Over the last four years or so, module prices have fallen from around $3.50-$4 per watt to around $1.30 today. Three years ago the industry was talking about reaching $1 a watt in ten years' time. We are now probably within two years of achieving that. At $1 per watt, the total installation cost is about $2 per watt. At that price in California, you are looking at a cost of around 10 cents or 11 cents a kilowatt hour which is cheaper than residential electricity prices (15 to 16 cents a kilowatt hour) by a reasonable margin.

The big fall in module prices left a number of companies with high-priced inventories; that really hurt them in the short term. But manufacturing and polysilicon costs are falling sharply at the same time. So it's not quite as simple as the price comes down, everyone gets screwed'. The other issue is that the industry is subsidy-driven today. These subsidies have been erratic, and are structured so that they come down at the end of every year. After the price drops, module manufacturers tend to keep their prices high, until they realise no one is buying, and suddenly they have to drop the price. So you get a really lumpy industry, but the underlying cash margins are good because of the continuous cost improvements.

But in the next three to four years, more and more countries will move away from being completely subsidy-driven. In three years' time, Germany shouldn't need to offer subsidies. They could just offer people guaranteed retail electricity prices for solar electricity produced, because retail prices are higher than the feed-in tariffs are likely to be. So you won't suddenly have an artificial reduction every year. That will lead to a step change in growth for the industry. For a residential package in the US, if someone wanted a 4-kilowatt system on their roof and it cost $2 a watt to install, that's $8,000. If you are paying $1,000 a year for electricity, and solar panels can make that go away, that's a very attractive proposition, particularly if you can just take a mortgage out at 5% to fund it and get a 10%-plus yield in return.

John: If solar got to that point then surely we would all have panels on our roofs?

Edward: In the long run, I think solar penetration will be much higher than is being forecast today. This will necessitate a change in the relationship between consumers and utilities. Already in Germany, the conventional utilities are now complaining. They get paid high prices for their peaking' power: if you have a natural gas plant that can be fired up in the middle of the day at short notice, you can get paid $100 or $200 a kilowatt hour. But because it is typically sunny in the middle of the day, there are now far fewer moments where peaking power is needed. This is the first glimpse of the changing relationship between utilities and electricity consumers. The utilities will eventually be more responsible for the security and balance of the system, and not necessarily for producing the bulk of the energy within that system. That's a very different economic role.

Alastair: I am also pretty bullish on the medium-term outlook for solar. But making money is hard, because it is so volatile. I compare it to the semiconductor industry. With smartphones and the rest, we are using an awful lot more semiconductors than we did ten years ago. Yet, in general, if you had bought and held the semiconductor sector, you wouldn't have made much money over that time. Solar has similar problems in that it's a semiconductor product but without high barriers to entry: there are very few patents. So the industry outlook is very strong, but whether or not that translates into good investments is probably more to do with your timing.

Edward: There is a second part to the story, however. Eventually solar will be competing against conventionally generated electricity prices, rather than being subsidy-driven. Let's say that electricity is sold for 10 cents per kilowatt hour. Once solar gets below that point, it is no longer competing solely with other solar companies, it's competing with the whole electricity sector. So there is no need for prices to keep falling. Solar accounts for under 1% of world electricity generation today. If you thought that could become 15% or 20% over a five or ten year period, you will clearly have a period where there should be super returns for some time while that transition happens. So we're not just talking about a commoditised industry that's going to compete itself into the ground, which is the difference between solar and semiconductors.

John: What about wind? Isn't it hugely subsidised and unsustainable?

Alastair: Wind does get subsidies, but so do most forms of power generation 90% of such subsidies go to fossil fuels. All the subsidy does is to enable a new investment to compete against marginal power. If you've got a fully depreciated coal plant, it's always going to be cheaper to extract a bit more coal, so you will never build any new capacity if you don't need it. Given a level playing field, wind is broadly cost-competitive, particularly in the UK, where the conditions are quite good. But that's onshore wind. The UK is focused on offshore wind, which is more costly the price will fall over time, but it is harder to build a wind turbine offshore than onshore.

John: Why offshore? Because people object to wind turbines?

Alastair: Yes, and if you are a politician, it's difficult to support something when voters are telling you they don't like it.

John: So what stocks would you buy?

Our Roundtable tips

Swipe to scroll horizontally
Exxon MobilUS: XOM
PetromineralesTSX: PMG
Africa OilTSX: AOI
CoveLSE: COV
BGLSE: BG
VerbundVie: VER
Trina SolarUS: TSL
China LongyuanHK: 916
EDP Ren.Port: EDPR
Schneider Ele.France: SU

Richard: I don't think you can go wrong with Exxon Mobil (US: XOM) to cover integrated oil. I used to work for Exxon. It is obsessed with shareholder returns you cannot collect a rubber from the stationery cupboard without justifying it and it doesn't fail to deliver. While other companies are worrying about where next year's reserve replacement will come from, Exxon head Rex Tillerson is worried about 2035. They are obsessed with energy, and they are good at it.

The other area that has been expensive but has got a bit cheaper lately is Colombia. There is a little bit of an issue over transportation, but that will be sorted and there is low-hanging fruit around existing fields. So I'd probably add Petrominerales (TSX: PMG). That leaves Africa. Africa Oil (TSX: AOI) could fail badly or do phenomenally well. It was spun out of Lundin Petroleum and is in a number of the onshore basins in Tanzania and Kenya which, it is hoping, will mirror the Albertine region that Tullow has exploited so well.

Steve: BG Group (LSE: BG) is one of our core energy holdings. The business had a tough start into this year with unrest in the Middle East disrupting operations in Egypt and Tunisia and a surprise change in the North Sea tax regime causing some concern. But with gas becoming ever more popular as a clean' alternative to coal, BG's portfolio of assets stands it in good stead for the future. In recent results the board also highlighted that its joint venture with Petrobras was meeting very best expectations'.

We also like Cove Energy (LSE: COV). It's partnered with Anadarko in the east African basin. Exploration has so far yielded around 12 trillion cubic feet of gas, subject to appraisal. At an investor conference, Anadarko announced that it believes its stake is worth $3-5bn, which if applied to Cove's 8.5% stake, translates to a share price of 88p-147p.

With significant other assets in its portfolio including a stake in several blocks in offshore Kenya in partnership with BG and results from seismic and appraisal drilling in Mozambique, Cove looks well placed to benefit from growth within the region.

Edward: One recent purchase, after Fukushima, was Verbund (Vienna: VER), an Austrian hydro-utility. With German nuclear coming off, we expect central European electricity prices to keep rising. As a hydro-utility, almost all of Verbund's assets are well depreciated and operating costs are low. So it should be a direct beneficiary of rising electricity prices.

On the solar side, there is Trina Solar (NYSE: TSL). It's a market leader; it's cost-competitive; the company has good management and it's trading on a mid- to-single-digits earnings valuation, although the earnings figure can move around a lot, given the volatility of costs and revenues.

Third is Chinese wind developer, China Longyuan (HK: 916). Its principal assets are a pipeline of wind farms in China and existing wind farms. China has seen huge growth in wind it is now the world's leading installer of turbines. This growth will probably plateau for a year or two, meaning turbine prices in China are likely to fall, while the price China Longyuan is paid for electricity generated is not likely to come down. Its profitability should improve as a result of these lower turbine prices and stable tariffs.

Alastair: My own suggestions would include EDP Renovveis (Portugal: EDPR), the Portuguese wind farm developer. There is some political risk near-term with the eurozone upheaval. But most of the group's assets are in the US. The stock has been heavily de-rated, partly due to Portugal's situation, but also because of pessimism over the outlook for wind. It's trading on 0.7 times book. But these are assets that are delivering very visible 20-year cash-flow streams.

So if the company stopped investing in any future capacity today, it would be giving you a double-digit free cash-flow yield. For me, that's structurally undervalued; you are not fully valuing the existing investments, let alone the growth.

Edward: And a large part of their assets aren't in Portugal.

Alastair: Yes, about 85% of their assets aren't in Portugal. Mainly in the US and other European countries but the US is the major end-market.

I also think that energy efficiency is going to become much bigger. At the larger end, we might look at something like Schneider Electric (France: SU). It's a French electrical engineer, but about a third of its earnings come from energy efficiency, and we think that will be the main growth driver. It is still trading on a similar multiple to the rest of the sector, yet has a structurally much stronger growth story.

John Stepek

John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news. John joined MoneyWeek in 2005.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.