Oil has been the best-performing asset in 2021 so far, but the risk-reward trade-off for the sector is now unattractive, with the winners of this year unlikely to repeat their exceptional performance in 2022, experts have warned.
The iShares Oil & Gas Exploration & Production UCITS ETF has been the best-peforming fund across the 5,074 strong Investment Association universe so far this year.
This is not a one-off, as nine of the top 10 funds this year all had some link to energy, either investing directly or in energy infrastructure.
Much of this is due to the price of oil, which has spiked 73.7% this year after dropping 37.1% in 2020.
Oil spot price increase in 2021
Source: FE Analytics
Janet Mui, investment director at Brewin Dolphin, said that there had been a swathe of issues with alternative sources of energy this year that boosted the price, while “exceptional” global growth increased demand.
“Global growth is almost 6%, with Chinese growth at 8% and the US at 6%, as people have come out of the lockdown, creating a sudden surge in demand. This is exceptional and one of the best years of the decade,” she said.
At the same time, wind speeds have been unusually low in Europe, with Norway and Germany in particular struggling to create enough energy from renewable sources alone.
“There has also been this ongoing geopolitical issue between Russia and Europe, so there isn’t enough cheap Russian gas coming into Europe. This caused gas prices to spike and oil is the alternative to this, so prices were bid up,” she said. Meanwhile, China restricted coal production, which has created further demand for oil.
At the same time, the Organization of the Petroleum Exporting Countries (OPEC) has added little extra supply to dampen prices, she added.
“All of the moving parts went wrong, which is why the oil price spiked so much, but it is debateable as to whether this will be repeatable in 2022. We think the oil price should moderate in 2022, so those performances have peaked,” said Mui.
There are also issues over the longer term. Energy companies are transitioning away from oil towards more renewable options, but this takes time and money.
Kamal Warraich, investment analyst at Canaccord Genuity Wealth Management, said: “The transition the oil majors must make is huge, with very high costs. The return on capital for their renewable businesses could potentially be very low.”
However, it is not simply a case of divesting. Some investors will see these stocks as attractive income options as they pay high dividends, while others will look to make short-term gains on the oil price.
Patrick Thomas, head of environmental, social and governance (ESG) investing at Canaccord Genuity Wealth Management, said there were two types of investor in the energy sector.
“Value guys buying the short-term cashflows show they aren’t bothered about ESG, while there are growth fans wanting the long-term renewables story,” he said.
Mui said investors buying traditional energy stocks needed to consider the implications of renewable energy, pointing to BP as an example of a stock that is investing in greener energy alternatives, which could change the long-term potential of the company.
However, she said that at the moment, investing in these oil majors represented a major gamble.
“The risk-reward is not worth it. There are better opportunities elsewhere. You want to be in a sector where there is large long-term secular growth prospects where there is trillions of pounds of investment,” she said.
As such, she suggested investors stick with the big American technology companies that have performed so well over the past decade, but have been out of favour this year.
“We have increased our allocation to the US and have been bulls on the market and particularly the tech and consumer discretionary areas, but you have to distinguish between the tech stocks that have done well purely because of the pandemic and lockdowns,” she noted.
“Some companies do not generate a lot of cashflow or profit, but were supported by extreme liquidity and investor sentiment during the lockdown.”
The firm continues to like the big technology giants, which she said were “well positioned” for future innovation, which should improve efficiencies over time.
“Overall, we like the innovation and growth prospects, irrespective of bond yields. Even if interest rates picked up, there could be an initial wobble, but we don’t think it would be a headwind over the long term,” she said.