The weighting of energy sector securities in Reaves’ portfolios has steadily fallen in recent years, culminating in the lowest sector exposure in the Firm’s history. Today, we review the reasons why.
At Reaves, we concentrate our research on essential service infrastructure businesses. Our goal is to build bottom-up portfolios consisting of companies that have the potential to grow earnings and cash flows sustainably over the long term. We believe oil and gas companies may struggle to meet this goal as the industry faces long-term challenges from declining renewable energy costs and ongoing climate-based legislation.
Declining renewable energy costs have been the biggest headwind. Since 2010, the cost of solar energy has dropped from $140 to $25 a megawatt hour, while costs for wind energy have fallen from $55 to $10, an over 80% drop for both (please see chart below). These technologies are inevitably poised to grab market share from the oil and gas industries. Other resources may play a part as well, with hydrogen recently emerging as a potential alternative to natural gas for home heating, power generation, and transportation.
Source: NextEra Investor Presentation, Edison Electric Institute Conference in Orlando, Florida, November 10-13, 2019.
Government policies have also been effective at steering consumers away from oil and gas. Specifically, tax credits for renewable energy investment has led to a construction boom in the United States and Europe. Governments are incentivizing electric transportation, and we believe these incentives could increase as global auto manufacturers dedicate more resources to electric vehicles. Meanwhile, consumers are also voting with their feet, demanding not just electric vehicles, but more efficient lighting, appliances, homes, and offices.
Historically, demand for fossil fuels has grown along with population and economic conditions, but the challenges posed by renewable energy, legislation, and changing consumer preferences could cause demand to plateau and eventually fall. Without long-term demand growth, companies within the sector have increasingly become a proxy for short-term swings in commodity prices resulting in much higher volatility. Such volatility conflicts with our goal to produce total return portfolios with low risk.
Collectively, we believe these changes are likely to come at the expense of oil and gas companies, but they may present opportunities for companies that develop renewable resources, like utilities. Many merchant power developers and electric utilities have helped to usher in this renewable energy transition, and companies with key technological and knowhow advantages have been at the forefront of pushing down costs of new energy sources. We have and continue to be active investors in companies helping facilitate this ongoing energy transition.
Going forward, we continue to focus on companies that can produce consistent earnings and dividend growth. Oil and gas companies may struggle to do this, but at the same time, the transition could create opportunities for those that develop renewable energy.
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