The world still needs fossil fuels – here's how to invest

Our enduring need for oil and gas heralds a boom in exploration and production, says Andrew Hunt.

The boom in energy prices has taken us by surprise. Oil prices have leapt to multi-year highs, while gas shortages are affecting everything from ice cream to dentistry. Even coal has made headlines as one of the best-performing asset classes of the year.

Many people had assumed that fossil fuels were obsolete and we could live without them. It turns out we can’t. In fact we need more of them and will for decades to come: the International Energy Agency (IEA) estimates that global demand for oil will grow at 1% or 2% a year; and our appetite for gas will expand at least twice as fast. Even coal consumption is set to rise modestly. 

Given all the progress with renewables, how can this be? When prosperity and innovation grow, so does demand for energy and fossil fuels. For example, when cars became more fuel-efficient in the early 2000s, Britons spent their petrol savings on foreign holidays. Renewables only partly offset this. Moreover, while the EU might be pushing green energy, it has only 450 million people. Since 2009 the world has added more than a billion people to its population, and two billion to its middle class.

From feast to famine

Even though demand has been rising, the fossil-fuels industry has been caught in a downturn. This was triggered by a supply glut, thanks to the boom in US shale (over the past decade or so, improved drilling techniques have allowed explorers to extract oil from rock formations previously deemed inaccessible). Since then, concern over climate change and a focus on environmental and social governance (ESG) issues have discouraged new investment, with the pandemic delaying exploration further. 

The result is that over the past five years the world has discovered about 12 billion barrels of oil a year and consumed three times as much; 2016 saw the lowest rate of new oil discoveries since 1946.Unsurprisingly, global stockpiles are falling.  

A particular headache is US shale. It has dominated supply growth over the past decade, with the US overtaking Saudi to become the world’s biggest energy producer. But shale production is now in decline. The best prospects have been drilled. 

The trouble with shale wells is that they decline very quickly. A conventional oil well might decline by about 4% a year. A shale well declines 80% in the first two years. US shale supply is about to fall off a cliff. The only way out of this predicament is to drive a new boom in oil and gas production. Whatever your moral instincts, rising prices and desperate governments are likely to ensure it happens.

That spells opportunity for investors. As in the gold rush, the best way to make money will be to buy the “picks-and-shovels” companies supplying the explorers rather than the explorers themselves. In this case, that means investing in energy-services companies. Energy services encompasses an enormous range of businesses. There are rig yards, suppliers of ships, helicopter companies, staffers, seismic surveyors, engineers and manufacturers of specialised equipment.

The one thing all these businesses have in common is that they are incredibly cyclical. Almost every stock highlighted below went up at least tenfold in the last boom and subsequently fell by 90%. Oil and gas investment cycles are long. The last boom ran for over a decade, and the subsequent bust pushed many into bankruptcy (which should mean bigger profits for the survivors). The recovery has yet to get going, but it is inevitable: we need more fossil fuels. 

Because these businesses are risky and cyclical, there are certain ground rules for investors. Firstly, you should do your homework. Understand the businesses and the financial risks. Secondly, diversify. Invest in a basket of them rather than relying on one or two. And thirdly, don’t sell too soon. As earnings recover, the upside is likely to be several hundred per cent over a few years. 

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