In the wake of the United Nations-sponsored Conference of the Parties (COP26)—now you know what it stands for—in Glasgow it is time to air some thoughtful disagreement again. Today the discussion revolves around environmental, social, and governance (ESG), green energy, decarbonisation and fossil fuels. You may ask, why go there? Because I sniff an opportunity. The Glasgow Climate Pact was a watered-down agreement, disappointing those who wanted thermal coal banned from the suite of energy producing options. The president of COP26 Alok Sharma apologised for the outcome. “I am deeply sorry” and “I also understand the deep disappointment.” Belatedly, the language around fossil fuels changed. The demand to “phase out” coal power became “phase down of unabated coal power”. The disgruntled and disappointed blamed China and India, the two most populous nations representing about 37% of the world’s inhabitants. COP27 will be held next year in the Egyptian resort town of Sharm El-Sheikh, known for its sheltered sandy beaches, clear waters, and coral reefs. There will be plenty of emissions aired getting the occupants of the climate change caravan to the location. While coal is seen as the demon, other fossil fuels including crude oil and liquefied natural gas (LNG) are also in the sights of those actively demanding net zero emissions targets. I am no expert, but then again neither were most of the negotiators at COP26. Their backgrounds are mostly political and very few would have had any experience in running a commercial business. The costs associated with attaining zero emissions targets for CO2, which is less than 0.05% of the earth’s atmosphere, will be too large to be absorbed by companies. They will be passed on to consumers one way or another and become deeply embedded into operating cost structures with longer-term inflationary implications. Shareholders will also share some of the burden. Meanwhile, the sponsoring United Nations is having difficulty spotting the difference between a developed economy and a developing one. The world’s second largest economy, China, is still classified as developing, which must puzzle many, even those attending the COPs. One can understand China and India’s reticence to phase out coal power. Both need to meet the surging energy demand from their growing and increasingly better off populations. China has 1,082 coal-fired power stations in operation, with a further 43 planned. India has 281 operating coal-fired plants. China accounts for over 50% of all coal-generated electricity. President Xi Jinping gave some ground in September pledging not to build any more coal-fired plants abroad under the Belt and Road Initiative (BRI), but that does nothing for the domestic plants under construction. Under the BRI initiative China has financed US$45bn in coal-fired projects. These plants in underdeveloped countries have operating lives of at least 35 years and will likely be operating post 2050. Investors are abandoning the fossil fuel energy sector, spurred on by climate change euphoria and the urge to participate in the flavour of the month ESG investment and “green” energy. All the while they are being egged on by the opportunistic Exchange Traded Fund industry. Oil and gas and thermal coal stocks have endured consistent and persistent selling for months which will ultimately dry up when portfolios are rebalanced. When all those not wishing to invest in the sector have achieved their goal, the opportunity will present.

Are fossil fuels the new tobacco?

Today’s situation reminds me of what happened to the tobacco industry some 30–40 years ago. In the post anti-tobacco campaign era, Altria, the parent company of Philip Morris was founded in Virginia, US in 1985 and was one of the most successful stocks listed in the US over the next 30 years. It spun-off the successful Philip Morris International (PMI) business in 2008. Altria shareholders received one PMI share for each Altria share. The tobacco industry was in decline in the mid-1980s but had been so for the previous 20 years. Statistics reveal US cigarette consumption peaked in 1981 at 640 billion and by 2007 had declined to 360 billion. By unit sales, the industry is one of the least successful of all US industries since Altria was founded. Perhaps the photography industry, which saw the demise of Eastman Kodak in the wake of Polaroid and missed opportunities in digital photography, could challenge it. In 2020, Altria’s group revenue and net income were US$26.2bn and US$4.45bn, respectively. In the 12 years 2009 to 2021 the compound average growth rate of dividends per share is just over 8%. The current yield at US$45 is 8.2%. PMI’s current yield is 5.6%. Morningstar has just added PMI (wide moat, medium uncertainty) to its Conviction Long Portfolio. Because tobacco companies cannot advertise, and innovation is not necessary they avoid meaningful associated costs. Where would Apple be if it did not advertise or more importantly innovate? Apple needs to reinvent its products every few years. Can it continue to do so for the next 20 years at the past rate? Currently the market thinks so. The disdain for fossil fuels is anti-tobacco revisited. Pension funds and other large investors abandoned tobacco stocks en masse and lighting up did become less popular. But smoking continues, tobacco companies are profitable and long-term total returns have been well above average. Many investors are repeating that earlier behaviour with fossil fuel stocks. Oil, natural gas, and LNG along with thermal coal will still be in demand in 2050, albeit in lesser volumes, just like tobacco. Just as was the case with tobacco, no advertising or innovation is required to market fossil fuels. They are what they are. Remember, total return has two components, capital and income and the percentages from each can vary over time.

Don’t write off hydrocarbons just yet

Recently, Morningstar released a 105-page Energy Observer—The Future of Oil Demand—Reports of its Death have been Greatly Exaggerated. I have distilled it to just four pages for your consumption and thoughtful digestion (see pages 4–7). Recall, our Energy analyst Mark Taylor’s Overview in YMW 35 of 16 September—“Don’t write off hydrocarbons just yet. I urge a quick revisit. Some of the pertinent paragraphs were as follows: “And a scenario where all hydrocarbon use disappears rapidly is unrealistic. Two-thirds of Australia’s coal exports by value are metallurgical, and at this stage there is no realistic alternative for coking coal in steelmaking. Additionally, Australia’s thermal coal is some of the cleanest on the planet, meaning it could be some of the last to feel volume erosion due to emission concerns. There are material differences between the types of coal—something that doesn’t exist much in natural gas. The brown and low rank coals are first in the gun sight—and there is a long runway of those.” “Barring the pandemic, global primary energy consumption has continued to rise by around 1.7% per annum due to growing population and per capita incomes. To reduce emissions, renewables must not only replace conventional energy supply, but also meet increased demand for energy overall. They have not managed this task to date. For the past five years global renewable energy supply excluding hydro power grew at an annual average 2.7 exajoules, still well below the approximate 5.5 exajoule growth from all hydrocarbons. Renewables still comprise less than 5% of the global primary energy supply mix with much work to be done.” “Within hydrocarbons, natural gas has grown fastest at around 3.0 exajoules or 2.5% per annum, ahead of oil at just over 2.0 exajoules or 1.1% per annum and coal at 1.2 exajoules or 0.8% per annum. Hydrocarbons make up 85% of the global primary energy supply mix. We anticipate natural gas growth to remain strong, continuing to eke share from coal and oil. This is the main game for Woodside and Santos with their gas predominant production mix.” So, another session of thoughtful disagreement closes, but it is not the end. The choice and decision of whether you as an investor want to have exposure to fossil fuels is up to you. That is not necessarily the case if you are a member of a superannuation fund. That decision is made by the manager, who is paid by the members. For those looking for material undervaluation, the fossil fuel sector may harbour opportunity. Woodside Petroleum (ASX:WPL) and Beach Energy (ASX:BPT) are currently in 5-star territory, while Santos (ASX:STO), Whitehaven (ASX:WHC) and New Hope Corporation (ASX:NHC) are 4-star recommendations.

Is it time to get defensive?

The bull run from the lows of March 2020 has been spectacular. Since then, rock-bottom official interest rates have been untouched. The Australian rate at 0.10% and the US Federal Funds rate also effectively 0.10% (0.0%–0.25%). Equities markets reacted positively with heavyweight technology counters like the FAANGs + M (Facebook, Apple, Amazon, Netflix, Google, and Microsoft) leading the charge. The NASDAQ Composite has more than doubled (+114%), S&P 500 +90% and the S&P/ASX 200 up 63%. Year-to-date gains of the above indices are 23%, 25% and 12%, respectively. These are unlikely to be repeated in 2022. Global central banks have added US$10–15 trillion via quantitative easing asset purchases and government’s fiscal programs put several trillions more into consumer’s pockets, in many cases regardless of need. These policies acted in unison, something not previously encountered. Ray Dalio at Bridgewater called it MP3—third generation monetary policy. The post-GFC rescue was MP2, where quantitative easing was introduced, without the associated firepower of government stimulus acting in unison. The inflationary outcome was modest at best. There was no great stimulation of demand as the focus was on correcting a credit contraction. Not so with MP3, which was a massive injection to protect incomes as coronavirus spread, administered without mandate. Supply chains were being disrupted as the virus impacted the labour force and massive shortages ultimately resulted as record levels of demand overwhelmed supply. The resulting mismatch between expanding demand and contracting supply is delivering goods inflation in spades. Demand does not look like backing off any time soon and central banks are in no hurry to intervene. They cannot influence supply. It’s demand stupid! UK manufacturers just reported the strongest growth in orders since records began in 1977. When the orders will be satisfied is anybody’s guess. Probably sometime well into 2022. As Dalio and Bridgewater succinctly put it, “The MP3 response we saw in response to the pandemic more than made up for the incomes lost to widespread shutdowns without making up for the supply that those incomes had been producing.” But as inflationary pressures persist so bond yields rise, which is not ideal for the sky-high valuations of NASDAQ companies. Perhaps their many days in the sun are nearing an end as a more hawkish monetary policy trend gradually emerges. The value-over-growth scenario is, becoming increasingly more plausible. On NASDAQ, there were 559 new 52-week lows versus 220 new 52-week highs on Tuesday. With markets at elevated levels and valuations based on low discount rates stretched, investors should be questioning their risk tolerance. The “there is no alternative” (TINA) mantra has meant investors have moved further out the risk curve in the quest for adequate returns in a low interest rate environment. The higher the risk setting the greater the likelihood an investor will panic when markets correct. History shows that is a time to stay the course, but it is difficult if risk tolerance is fragile. When asset prices are high, generally future returns will be lower. In his latest Short Strategy, MST Marquee’s Hassan Tevfik reports Australia’s biggest investors have dialled up risk-on settings, evidenced by high equities and low cash and bond holdings. He estimates the equities allocation (domestic and international) at 56% and cash and bonds at 27% and postulates “the market may be missing an obvious buyer if it does correct.” The level of concentration in the US market is also of concern, with the top five companies, Apple (NAS:AAPL), Amazon (NAS:AMZN), Facebook/Meta (NAS:FB), Google/Alphabet (NAS:GOOGL), and Microsoft (NAS:MSFT), comprising a collective market capitalisation of US$10 trillion, accounting for 25% of the total S&P 500 market cap. Global liquidity is tightening with year-on-year growth of M2 slowing to 7.3% from a peak of 22% in March. That rate of change could suggest returns from equities may be subdued in 2022. Trying to find that extra 1% of return can involve much greater risk. Those in retirement or pension mode must continue to adhere to a strategy which satisfies their needs including income, security, longevity, and liquidity. Additional risk, including emotional, should not be a part of any sunset strategy.