Friday, July 2nd, 2021

A Difference of Opinion

We have a difference of opinion between US and European investors, regarding the Energy sector. In the US, it is ranked #2 and our model suggests a 46% overweight. In Europe, it is ranked #9 with a -24% underweight. This is not the first time US and European investors have taken a different view, and it certainly won’t be the last. But the Energy sector is the biggest point of disagreement between them at the moment and the relative optimism of US investors has just hit its highest level since late 2007.

There could be many potential explanations for this divergence. First, the US sector is more exposed to upstream exploration and the rising oil price. Second, US investors may be more inclined to think positively about the sector after the success of shareholder revolts at Exxon and Chevron. Third, there may be a greater percentage of US investors prepared to invest on a stylistic basis and commit to the value vs growth trade, which has obviously favoured Energy in recent months. However, we want to focus on another explanation, which is impossible quantify, but which could have significant long-term implications. We may have reached the stage where the application of ESG mandates in Europe prevents the European Energy sector from obtaining a competitive cost of capital. Many ESG activists would argue that this is a good thing and one of the key ways in which global emissions will be controlled, but it does not come without significant opportunity costs.

First of all, we should be clear that Europe is the outlier here, not the US. The Energy sector is ranked #3 in our model for China and #4 in Japan and was upgraded to overweight in both regions this week. Our enhanced multi-asset model, which is allowed to invest in commodities, now has any 18% weighting in crude oil, against the permitted maximum of 25%. This is the highest weighting since May 2008, and if it rises by another one percentage point, it will be the highest since March 2000. European investors may not want to invest directly in commodity markets denominated in US dollars, but they should be aware when this strategy starts to generate significant risk-adjusted returns.

Missing out on excess returns from “dirty money”, may be a price that fund managers and their clients are willing to pay for a cleaner, greener future. But there may be other problems too. First, investors should realise that a strategy which is designed to change the structure of an industry, may do exactly that, but not in the way they expect. For instance, if European oil companies do not have a competitive cost of capital, they may eventually be forced to cede control of current or future projects to non-European companies with lower ESG standards. Second, if the buyers’ strike in Energy extends from Europe to the US, investors may find that the balance between OPEC and non-OPEC supply shifts back in decisively in favour of OPEC (plus Russia) for the first time in over 10 years. The implications for inflation in 2023 could be unpleasant.

As human being, this author wants a low-emission world just as much as his readers. As an analyst, I worry about the way in which progress towards it, is being sequenced. We risk significant, unintended consequences if we shift our investment style too far in advance of our lifestyle. Perhaps investment managers should only agree to implement a low-carbon mandate for clients who have already bought an electric car.

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