Opportunities in energy, from fossil fuels to green bonds

Global activity can’t happen without energy—businesses, families and nations need it every day. Yet when it comes to investing, the energy space is volatile. That makes it important to do proper research to define and implement an energy strategy in your portfolio that balances your risk tolerance and long term financial goals.

Here, we’ll suggest ways to consider investing in traditional energy , including passive strategies and an active approach in one sub-sector called “midstream.” We’ll also explore the universe of opportunities now in view as a result of the clean energy transition.

How should you invest in energy?

What investments within the sector do we think offer the most opportunity? How should you implement them in your portfolio? 

We see a range of opportunities (and risks) today in the industrial sector classified as “Energy.” That encompasses exploration and production, refining and marketing, storage and transportation of oil, gas, coal and consumable fuels as well as oil and gas equipment and services companies. We’ll also consider energy more broadly, to include green bonds and companies involved in the energy transition. 

Energy is a cyclical area of the market that often ranks as top performing or bottom performing versus other sectors (see chart below), so it requires a carefully thought-out investment approach.

Here are the investing ideas we like most in the broad energy space today.

In traditional energy, consider passive exposure

Traditional fuels continue to be relevant. While fossil fuel business profits may be strong or weak, depending on a myriad of economic and political factors, they also make up 70% to 80% of the global primary energy consumption that sustains global economic activity. Experts predict they will still be two-thirds of global primary energy consumption into 2050.¹

Our research suggests investors interested in exploring opportunities in fossil fuels should consider a passive approach—with certain exceptions. That’s because active managers have historically found it difficult to outperform here.

Why? It’s not just the high volatility. Energy stocks tend to move in unison because of the overwhelming influence of the commodity price cycle on energy company stock prices, so successful investments in this area require an ability to accurately time the commodity cycle itself.

Energy companies’ equities are less likely to move on stock-specific factors (like how well the business is managed, its financial strength, product innovation, etc). And it’s in gaining insight into those stock-specific factors (not accurately timing the direction of the commodity cycle) where active manager skill sets typically reside. According to our active manager cohort, this situation is aggravated by the extremely concentrated nature of the benchmarks that limit the ability to take meaningful active bets.

Implementation: Depending on your needs and goals, consider using passive vehicles (mutual funds and ETFs) for exposure to the whole traditional energy sector. The commodity cycle primarily influences equity prices here—not the stock-specific factors that active managers seek (management quality, say, or whether a company has hit its debt-to-earnings target).² For investors comfortable with potential volatility, an ETF can provide low-cost, diversified exposure.

A bright spot for active: The midstream space

In contrast to the general challenges faced by active energy sector focused strategies, there is an exciting opportunity for active investing in energy midstream. This is a critical segment of energy infrastructure that moves product from extraction to consumption.

The midstream business model centers around long-term contracts that tie revenues to volume transported. Contract prices are typically indexed to inflation, with minimum volume commitments. All this translates into more recurring revenues and less exposure to commodity prices than companies that, for example, do exploration or production.

Energy midstream has been under-researched. This means good companies may fly under the radar, so less sell-side coverage becomes conducive to wider dispersion in equity performance estimates. The consequence may be more opportunities for active managers. Compared to the broader energy sector, midstream companies have also exhibited generally weaker correlations to each other.

These anomalies that characterize the midstream part of energy can be seen in its outperformance versus energy overall. Over the past 15 years, active energy investment managers have underperformed the S&P 500 Energy Index, yet active energy midstream investment managers have outperformed—not just the S&P 500 Energy Index but also the midstream index, the Alerian Midstream. 

Implementation: Depending on your needs and goals, consider master limited partnerships (MLPs) for the potential tax benefits. Some midstream company investments are structured as MLPs, which are noteworthy for not being taxed twice, like common stock dividends can be. MLPs tend to generate higher yields than stocks or bonds in part due to this favorable tax structure.³

Diversify with real assets

Real asset managers are positioned differently than traditional energy sector managers: They seek to diversify their portfolios, not exclusively holding oil and gas assets. They invest in a range of assets, such as real estate, precious metals, and other natural resource equities; and with recurring cashflows based on long-term contracts with a lower degree of economic sensitivity, such as pipelines and other infrastructure. This diversification should help investors avoid traditional energy’s historically high cyclicality and volatility.

Implementation: Depending on your needs and goals consider diversified real asset managers. This approach may capture superior risk-adjusted returns versus pure oil and gas passive investments that may be more volatile given a greater diversity of business model characteristics, offering opportunities for portfolio diversification. 

Positioning clean energy exposure in your portfolio

The energy transition will be an evolution that depends on an infrastructure buildout yet to come, one that will touch multiple market areas: the supply side, the demand side and the supporting infrastructure related to the energy transition. Given this breadth, a range of market drivers are setting the stage for a potential clean energy investing boom.

The economics for growing the adoption of clean energy solutions have shifted. In past decades, renewables were expensive and subsidy dependent. Nowadays, renewables are the cheapest power source in most parts of the world.

Importantly, the universe of investible renewable energy opportunities spans companies in power production (the supply side) but also transport, manufacturing, buildings (the demand side), info tech, and energy infrastructure such as networks and grids. That means an investor has many opportunities across the full value chain of this transition.

Finally, we also expect this universe to continue to expand, evolve and become more complex, making it more difficult for the market to understand. That would potentially create opportunities for dispersion in returns that a dedicated active equity manager could be well positioned to capitalize on.

Implementation: Depending on your needs and goals, consider active equity managers. Unlike traditional energy sector stocks, the stocks in this investible universe also lend themselves to active management because they do not generally move in tandem. That tendency to low correlation, along with the sector’s evolving complexity, should help create a wide dispersion of returns, potentially fertile ground for active equity managers.

Go active: Fixed income in the energy transition

Debt financing represents a large-scale funding source likely to be significant in the energy transition, especially as investment flows are required for the shift towards sectors, such as electricity, where debt finance is already common. Debt instruments’ long-term characteristics also align well with the long investment horizon that climate-oriented developments need.

Debt capital markets are also much larger than equity capital markets. To really effect change and contribute to the transition, one may consider a fixed income allocation.

Fixed income boasts a long history of average active managers beating market benchmarks. That’s related to inefficiencies in index construction. For example, indices are obliged to include a growing proportion of lower quality issuance, as more exists today than in the past. New debt issues also make up a significant proportion of the market. An active manager can decide when to participate and at what level, giving them an advantage over a passive approach. owing when to participate and at what levels can give an active manager an advantage versus a passive approach. 

Green bonds specifically involve some are additional complexities that lend themselves to an active approach:

• Passive bond indices, although they track historical environmental, social and governance (ESG) ratings by issuer, may not always keep up with developments in this fast-moving market. They may miss green bond opportunities that are available to active managers. 
• Active managers will look beyond the bond issuer’s rating to consider how the proceeds will be used. They can do a sophisticated analysis and be highly selective in their funds.
• Active managers can engage with companies that are repeat green bond issuers, seeking to drive them towards better disclosure of their practices and aligning their use of bond sale proceeds with energy transition goals. 

Implementation: Depending on your needs and goals, consider cost-efficient fixed income approaches focused on bond investments targeting the energy transition. This approach can provide opportunities to generate income in a dynamic part of the market.

Whether your needs are for diversification, income or investing with your values in the transition, the energy transition can offer a range of investment opportunities. And knowing how to access them is equally as important.

To find out if energy-related investments suit your portfolio; to understand the sector’s volatility, how it might be managed and how to effectively access energy transition-related opportunities, reach out to your J.P. Morgan team for advice personalized for your goals and risk profile.

¹Author if any, “Name of document or database,” International Energy Agency, DATE.

²Another positive factor: Midstream companies’ business models center on long-term contracts tying revenues to volume transported—more characteristic of infrastructure investments than energy.

³Consult your professional tax advisor for guidance on your individual circumstances.