03-Nov-23 ESG

Unintended peak oil

The oil and gas sector has been strongly outperforming the alternative energy sector. There are many reasons for that. Higher interest expenditure is one of them.

Can there actually be a more attractive sector? Insatiable demand, intense desire socially and from political leaders, tax and other incentives, and, last but not least, high barriers to entry given the high level of innovation required and the benefit of big economies of scale? We are talking about alternative energies. But the attractiveness of the sector is certainly not evident at present in its results. On both sides of the Atlantic, companies connected to alternative energies have regularly been among the most negative outliers. The profit warnings have not stopped for some time. Supply chain problems, cost inflation and higher interest costs are the main reasons given for the sometimes glaring earnings misses.

Aren't all sectors facing these problems? As our Chart of the Week shows, alternative energies have been hit particularly hard. Relative to the overall market, they have been performing disappointingly since early 2021. And since the beginning of this year, their woes have worsened. Is the problem the sector's high level of capital intensity? One argument against this is the very strong performance of the oil sector, which the chart also shows. So let's start from the beginning.

Relative performance of traditional and alternative energy sector vs. Fed funds rate

* MSCI World Integrated Oil & Gas relative to MSCI World (USD Net Return Indices)
** MSCI Global Alternative Energy relative to MSCI World (USD Net Return Indices)

Sources: Bloomberg Finance L.P., DWS Investment GmbH as of 11/1/23

In the face of increasing climate and environmental concerns, many companies in the energy sector are investing in renewable energy to improve their carbon footprint and provide more clean energy to their customers. Wind and solar energy have become increasingly competitive with traditional energy sources, such as coal and natural gas, in recent years.[1] This had made them an attractive investment for companies looking to reduce their dependence on fossil fuels. But unfortunately, that doesn't mean everything is encouraging for investors. Renewables are still low profitable[2] and, importantly, more unpredictable than traditional forms of energy due to higher dependency on nature resources. This makes it difficult for companies to diversify their energy mix while maintaining their current profitability. Not only solar and wind operators, but also their manufacturers are struggling to maintain profit margins, as evidenced by the recent earnings reporting season. The same does not seem to be true for the oil and gas sector.

As the chart shows, the performance gap between these sectors has been widening for some time. It gained even more momentum when the U.S. Federal Reserve (the Fed) began its rate hike cycle. This correlation is also based on causality. The alternative energy sector, which is still relatively young, is dealing with significantly higher levels of debt than the conventional sector. Based on the indices used in the chart, the average ratio of net financial debt to operating profit before depreciation and amortization for the alternative sector is 4.1 over the past ten years, while the ratio for the traditional oil and gas sector is only 1.6. Accordingly, higher interest rates weigh much more heavily on the alternative sector than on the traditional energy sector.

Given the social and environmental importance of alternative energies, the sector’s struggles are certainly not a source of schadenfreude for anyone. But we believe the sector could benefit from a more precise analysis of the reasons why so little money is currently being made in a sector that is vital for the world’s future and in theory highly attractive.

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