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.”
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.
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.
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.
Check out this interview I did with The Contrarian Podcast where I discuss this article, and much more.