Up in smoke: Why investors in oil companies may reap a climate rebellion dividend

What’s the connection between tobacco and fossil fuels? Not much you might think. Both are commodities of a sort.

Both of them have been at the centre of global anger. In the late 1990’s tobacco was feared, hated, and disgraced.

A recently updated post from Capitalist Exploits compares the current headwinds facing oil companies to those facing the tobacco industry in the late 1990’s. Capitalist Exploits lists all the things going against tobacco:

“An industry in decline. Widely considered to be murderous thugs. Banned from advertising via many traditional media channels. Fined by regulators. Enjoying a blizzard of litigation. No innovation in the industry.”

 Yellow smoke in dark
https://foter.com/photo3/yellow-smoke-in-dark/

Two decades on today’s equivalent is fossil fuels and the oil company specifically. Oil majors are taking heat from the courts, from the media, from the public, from banks and from investors:

Lawsuits over climate change proliferate across the United States – Reuters: “A trial in which Exxon Mobil Corp (XOM.N) stands accused of defrauding investors out of up to $1.6 billion (£1.2 billion) by hiding the true cost of climate change regulation is expected to wrap up this week.”

Do today’s global protests have anything in common? – BBC: “Of course, many of the protests that you hear about will have been linked to the environment and climate change. Activists from the Extinction Rebellion movement have been protesting in cities around the world, as they demand urgent action from governments.”

How Climate Divestment Won Converts With Deep Pockets – Washington Post: “Norway took a partial step in selling off oil and gas stocks in its massive $1 trillion wealth fund. And a growing number of investors who control trillions more are using the threat of divestment as a cudgel to force energy companies to adopt greener ways. Together these approaches are producing a notable disruption in the energy field.”

If today’s oil company was yesterdays tobacco company what does that mean for investors? Well, most people think that means don’t invest in oil companies. Putting aside any moral, ethical or environmental argument if no one else is investing then it can’t be a great investment.

The performance of the tobacco sector over the past two decades says something very different. Far from being the laggard, tobacco companies have outperformed the broader market.

Why do sin stocks outperform?

Companies selling alcohol or cigarettes among other human vices have enjoyed higher returns than the stock market indices to which they belong. Tobacco companies have even performed better than the pharma companies making cancer drugs to combat smoking-related illnesses.

Since all active fund managers seeking to make higher returns than the benchmark this in theory makes them ideal holdings. However, investors holding them can face reputational risk, particularly as lobbyists rally against industries known to harm human health, and as we will see later the environment.

A popular explanation for the observed abnormal returns of sin stocks is that they are under-priced because so many investors shun them. According to a 2017 research note by hedge fund firm AQR Capital Management (Virtue Is its Own Reward: Or, One Man’s Ceiling Is Another Man’s Floor), investors must be compensated to buy constrained stocks through higher returns:

“What happens when one group of investors, call them the virtuous, simply won’t own a segment of the market (the sin stocks)? Well, in economist terms the market still has to “clear.” In English, everything still gets owned by someone. So, clearly the group without such qualms, call them the sinners, have to own more than they otherwise would of the sin stocks. How does a market get anyone, perhaps particularly a sinner, to own more of something? Well it pays them! In this case through a higher expected return on the segment in question.”

A more recent explanation is offered by David Blitz, Head of Quantitative Research at Robeco, and Frank Fabozzi, Professor of Finance at EDHEC Business School, in their article Sin Stocks Revisited: Resolving the Sin Stock Anomaly published in the Journal of Portfolio Management. They show that the outperformance of sin stocks can be explained by ‘profitability’ and ‘investment’:

“The profitability factor means that stocks with a high operating profitability perform better, while the investment factor maintains that companies with high total asset growth perform worse. Sin stocks tend to have high exposure to both factors; cigarette makers, for example, enjoy high margins due to relative price inelasticity, and are restricted in how they can grow their assets.”

The new tobacco

In many respects the sector is facing a perfect storm with economic, political and social factors providing the foundations for similar out-performance over the next decade or two.

The switch towards electric vehicles, the recent decline in the price of oil since 2014 and the broader public revolt against climate change. Far from being a negative for the biggest U.S. and European oil companies, it could even be positive.

 Landscape with fog and chimney smoke at sunset
https://foter.com/photo3/landscape-with-fog-and-chimney-smoke-at-sunset/

The most important factor is the principle of “diminishing returns”: The more crude that oil companies discover, the lower the returns their investors can hope to achieve. This is because new reserves tend to be more expensive to develop than the earlier discoveries. This flaw was disguised for the past 40 years as oil prices rose even faster than the costs of exploration and production.

In a competitive market the rational strategy for major Western oil companies would be stop all exploration, while continuing to provide technology, geology and other profitable oilfield services to the owners of readily-accessible reserves. The vast amounts of cash generated by selling oil from existing low-cost reserves already developed could then be distributed to shareholders until these low-cost oilfields ran dry. In the real world of course, geopolitical conflicts and transport and infrastructure bottlenecks mean that consumers want energy security and will pay premium prices. Hence the need to explore and develop oil resources elsewhere in the world.

There are two reasons why this ‘rational strategy’ hasn’t happened thus far. Firstly, OPEC has sheltered Western oil companies from diminishing returns and marginal-cost pricing by keeping prices high. Secondly, oil company managements have believed in rising oil demand. Finding new reserves seemed more important than maximising returns to investors.

Peak oil?

Tobacco consumption has dwindled over the past few decades in a generational shift. The main exception being China where per capita tobacco consumption has continued to rise.

Moving to oil, there is wide disagreement on the speed to which consumption growth will slow and go into reverse. Many point to the continued growth in petrochemicals as a source of demand for oil, even as its mainstay – transport – declines. Either way the demand for oil is set to remain price inelastic across many end applications and markets for many years.

Meanwhile, Extinction Rebellion and other forces will serve to restrict the growth in the oil sectors assets. As tobacco and other sin stocks before it, restrictions on asset growth may help support the returns of their investors.

There is always a cost to everything in life, even (and perhaps especially) virtue.

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Why do economists have an abysmally poor prediction record?

Its true that economists have an abysmally poor prediction record. Before explaining why lets have a quick look at how abysmal.

The Economist magazine have a database of projections by banks and consultancies for annual GDP growth. It stretches back 20 years and now contains 100,000 forecasts across 15 rich countries.

Unsurprisingly they found that forecasts tend to fare well over brief time periods, but got worse the further analysts peered into the future. If a recession lurks beyond 2019, economists are unlikely to foresee it this far in advance.

Projections made in early September for the year ending four months later missed the actual figure by an average of just 0.4 percentage points. Errors rose to 0.8 points when predicting one year out. But over longer horizons forecasts performed far worse. With 22 months of lead time, they misfired by 1.3 points on average—no better than repeating the previous year’s growth rate.

The most likely outcome is growth – economies usually expand slowly and steadily so its reasonable to forecast this. But sometimes unfortunately economies contract sharply…

…and this means the biggest forecasting errors occurred ahead of contractions. The average projection 22 months before the end of a downturn year missed by 3.7 points, four times more than in other years. In part, this is because growth figures are “skewed”: economies usually expand slowly and steadily, but sometimes contract sharply. As a result, forecasters seeking to predict the most likely outcome expect growth.

So why are they so abysmal?

Well, first the economy is a complex system full of positive and negative feedback loops. And so it doesn’t necessarily follow that a change in one part of the economy (say a cut in interest rates by X) would automatically lead to an improvement of Y elsewhere. Its non-linear.

“Nobody has a clue,” Jan Hatzius, Goldman Sachs’ chief economist, said to Nate Silver in the book “The Signal and the Noise”. “It’s hugely difficult to forecast the business cycle. Understanding an organism as complex as the economy is very hard.”

According to Hatzius, forecasters face three fundamental challenges: first, it is very hard to determine cause and effect; second, that the economy is always changing and, third, that the data that they have to work with is pretty bad.

Second, economic forecasters of all stripes are prone to the same biases. They are prone to recency bias (thinking the current trend will continue), availability bias (only considering salient data and insights) and confirmation bias only seeking out information that confirms their worldview).

Finally, they are all subject to different incentives. And the main one is whether to herd, or not to herd. If a forecaster strays too far from the consensus forecast and turns out to be wrong they may lose their job or be passed over for promotion.

As the great investor Warren Buffet said, “Forecasts usually tell us more of the forecaster than the future.” Forecasters are too busy looking in the rear view mirror and looking across at their competitors to provide an unbiased forecast of the future.

Related article: Financial market forecasts: How to avoid buying a lemon

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The precious one

Two headlines caught my eye recently that demonstrate the power of sentiment in commodity markets. If you read my post from June (What headlines are telling us about sentiment in commodity markets) you’ll recall that headlines in the media (and especially in the financial media) tend to confirm what we already know, once a trend has been firmly established and often extrapolate that trend into the future.

The two headlines are from the FT and the BBC and both relate to the market for palladium. To recap, from a low of $470 per oz in early 2016 the price of palladium has more than tripled over the past three and a half years to almost $1700 per oz.

The first article (“There’s no end in sight for soaring palladium prices” – 2nd Oct, FT) notes the fundamental factors in support of the palladium price but the headline suggests that there is no end to the palladium price boom. Just as with headlines that suggest it can only get worse this headline suggests that bullish sentiment is ripe for a reversal.

The second article (“Huge rise in catalytic converter thefts” – 20th Sep, BBC) brings it home to the average car owner that although they may feel safe driving round in their SUV, in fact they are showing off to potential thieves that they have something that has tripled in value. When the impact of high prices starts to register with the end consumer it can be a sign that demand will start to wane.

The long term palladium chart looks stretched with prices well above the 50 and 200 day moving average while there are signs of a negative divergence that could indicate a sharp correction is close.

h/t @Richards_Karin https://twitter.com/Richards_Karin/status/1181508078090571776

Investment bank UBS sees further upside in the coming months but with an increased risk of sharp corrections:

“We see further price upside over the coming quarters, but performance will likely continue to be volatile with large price drops possible – as already experienced twice this year. Such corrections could be caused by renewed risk-off events and/or sales from Russia’s Nornickel Global Palladium Fund (GPF). It remains unclear how much metal the GPF still holds, however. Declining ETF holdings – which were used to cover the market deficits and are now at the lowest level since 2008 – suggest that above-ground inventories are quickly dwindling”

One of the oldest sayings in commodity markets is that the cure for high prices is high prices. It is exceedingly is rare for any commodity to remain this far above its long-term average for so long especially one where sentiment is so stretched.

Related article: Palladium prices: The top 10 most important drivers

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