AUTHOR

PAUL CHAVES D’OLIVEIRA

paulchavesdoliveira@edhec.com

An increasingly wide gap has been appearing in the energy sector recently, between renewable energy stocks and traditional ones. Green energy stocks have been significantly outperforming oil stocks to the point where certain analysts think they are overvalued and a bubble is starting to form. Almost as a symbol of oil companies’ fall from grace, ExxonMobil has been removed from the Dow Jones Industrial average last August, for the first time since it joined it in 1928. While it was the biggest company in the world in terms of market capitalisation just 10 years ago, ExxonMobil now represents investors’ decreasing appetite for oil companies, unlike renewable energy stocks which seem to only climb higher. To determine whether these stocks really are favoured by investors, we picked 5 stocks from each of those subsectors of the energy industry and from both European and American markets and charted the returns they earned over the last 5 years.

The overall returns for oil stocks are much lower than returns for renewable energy stocks. The combination of Covid-19 and oil supply shocks has resulted in historically low valuations for oil companies. However, even before these events, traditional energy stocks were earning significantly less than green energy stocks. There are many reasons for this to be the case, but they might not all be fundamentally related to these companies’ investment merits.

Are renewable energy stocks really valued that much higher?

It is possible there is an unfair investor bias in favour of green stocks, and more specifically, bias in favour of renewable energy over traditional energy companies. This bias could be the result of pressure towards institutional investors from regulators or their clients, which led to portfolio managers’ demand for greener stocks. An investor bias is not to be excluded and would be reflected in a large difference in the valuation multiples of renewable and traditional energy companies. Indeed, a lot of analyses pointing out a possible bubble come to that conclusion by comparing multiples, so we did that for our 10 companies.

A quick look at the numbers shows that renewable energy stocks are indeed valued at much higher multiples than their oil and gas counterparts. While this is consistent with the theory of a possible investor bias, it does not necessarily confirm it. There are valid reasons for these stocks to be valued differently, namely higher growth perspectives and different business models.

Different Growth Perspective

Growth perspectives for oil companies are extremely dependant on future demand for oil. Given the high volatility of oil prices, this would be enough for investors to value oil companies at a discount. When oil and gas companies decide to build a well, they have to spend years on research and construction before actual drilling can begin, and revenue starts to flow in. Estimation of a business model with such projection into the future is extremely complicated when prices of the commodity for which you are drilling are so volatile. On top of that, oil prices have been particularly volatile this year, due to shocks in demand and in supply. The global economic downturn provoked by the Covid-19 pandemic has had a significantly negative impact on oil demand due to the fall in global travel it caused. As coronavirus cases resurge around the world, investors interpret the perspective of a prolonged pandemic as a continued downward pressure on oil demand, and therefore oil stock prices. As for oil supply, the crash of March 2020 caused by Saudi Arabia and Russia’s inability to find an agreement on reduced oil production left the industry in distress and oil prices have not recovered since. On the other hand, although electricity consumption has been negatively affected by the pandemic, carbon-intensive electricity sources, especially coal, have borne the brunt of the fall in demand. As a result, demand for renewable energy has increased this year, which partly explains why green energy stocks have been among the only ones to earn a positive return in 2020. 

As for long term energy demand, oil consumption should keep growing over the next 10 years or so and should peak during the 2030s and stabilise at that level for the foreseeable future, according to the International Energy Agency’s 2020 World Energy Outlook report. 

Oil Demand by Scenario. IEA, Global oil demand by scenario, 2010-2040, IEA, Paris https://www.iea.org/data-and-statistics/charts/global-oil-demand-by-scenario-2010-2040

Due to the high uncertainty regarding the pandemic, IEA created different scenarios to estimate future demand for energy. The Stated Policies Scenario (STEPS) reflects governments’ current announced policies and assumes that Covid-19 is gradually brought under control in 2021, while the Delayed Recovery Scenario (DRS), under the same policy assumptions, assumes a prolonged pandemic from which the global economy recovers in 2023. The Sustainable Development Scenario (SDS) assumes a massive change in policy to achieve sustainable energy goals in full like the Paris Agreement.

Except in the Sustainable Development Scenario, which looks like such a radical shift in policy that it doesn’t seem quite as realistic as the other scenarios, oil use for travel should peak due to increased fuel efficiency and growth in sales of electric cars, despite increased demand in developing countries where rising incomes create a higher demand for mobility. Oil demand growth should therefore be more dependent on its use in petrochemicals, i.e. to make plastic. This use of oil does not create CO2 emissions, making it a credible source of use of oil in the long-term.

As for demand for renewable energy, the World Energy Outlook report foresees a massive surge, especially in wind and solar. Solar energy consumption should be multiplied by 5 and wind multiplied by 3 by 2040, even in the conservative Stated Policies Scenario. Coal use, which has already suffered the most from the pandemic out of all electricity sources, should decline no matter what. Natural gas consumption, on the other hand, should continue growing under current policies due to switches from coal to gas and its lower level of CO2 emissions. As many traditional energy companies are invested in gas as well as oil, this should create growth for them up until the mid-2020s, after which environmental considerations and increased competition from renewables should deteriorate prospects for gas.

IEA, Change in global electricity generation by source and scenario, 2000-2040, IEA, Paris https://www.iea.org/data-and-statistics/charts/change-in-global-electricity-generation-by-source-and-scenario-2000-2040-2

Overall, forecasting energy demand shows that renewable energy companies should enjoy substantial growth over the next years, unlike traditional energy companies. This partly explains the difference in multiples; as growth stocks, green energy companies are valued at much higher multiples than oil companies, now considered value stocks. It appears that the pandemic has accelerated the transition from CO2 emitting traditional energy sources to greener sources, but oil demand should not decline in the foreseeable future, unless strong policy changes are made. Naturally, traditional energy companies are not oblivious to the limited growth perspectives for high-carbon emissions energies. However, the transition process from those to renewables is slow and expensive, which is another reason why they are valued at a discount.

The role of politics

The factor of political uncertainty is therefore huge in the estimation of the growth perspectives of these companies, and the American ones were recently facing that uncertainty in the very short term. As polls for the US presidential election seemed to favour candidate Joe Biden and his environment-friendly agenda, which notably includes a $2 trillion plan to boost green energy over the next four years and end carbon emissions from power plants by 2035, oil companies have become significantly less attractive investments while the perspective of huge growth becomes more concrete for green energy stocks. On the other hand, Donald Trump’s plan for the environment was to bolster the company’s oil and gas industries and continue rolling back environmental regulations. However, polls have their limitations, especially concerning the US presidential election and its electoral college system. Markets were surprised by Donald Trump’s win in 2016, as runner-up Hillary Clinton was predicted to win in the polls, albeit by a smaller margin than the one Joe Biden now enjoys. In any case, markets favouring green energy stocks rather than oil companies due to election predictions might not have been the most fundamentally valid reason for them being propped up, due to the high uncertainty of these predictions. 

Joe Biden officially won the election, but the Senate is set to keep a Republican majority. This will impede Biden’s ability to implement his renewable energy plan and should therefore negatively impact the prices of green energy stocks. We can see the impact of election-related news on the following graph, charting returns on the SPDR Energy Select Sector (XLE) and First Trust NASDAQ Clean Edge  Green Energy (QCLN) ETFs, which respectfully offer exposure to US traditional and renewable energy stocks over the last month.

This graph shows only a few key moments among a particularly agitated election, but it is enough to see that results favouring Biden were clearly more beneficial to green energy stocks than oil companies. Surprisingly, the much-dreaded scenario of a tight race with Donald Trump refusing to concede has not resulted in a slump for either of the sectors, as markets seemed to believe firmly in a Biden victory early on. Biden’s victory was officially called over the weekend, but its impact on these stocks cannot be really analysed due to other news on the 9th of November: a 90% effective vaccine against Covid-19 announced by pharmaceutical labs Pfizer and Biontech. This has led markets to believe the end of the pandemic might be coming sooner than expected and has resulted in a global equity rally, which sectors most affected by lockdown measures enjoyed even more. This meant that oil stocks, which faced heavy downwards pressure during the pandemic, experienced a huge rebound on the 9th of November as vaccine news somewhat overshadowed Biden’s win. On the other hand, renewable energy companies which did quite well during the pandemic did not see their stock rise in the same way, and while Biden’s win obviously favours them, a Republican Senate would not pass easily his $2 trillion plan to invest in renewable energy.

Different business models

A closer look back at the multiples table shows something interesting. The only multiple which is not significantly higher for the average green energy stock considered is EV/EBITDA. This is partly due to disparities in the ten companies considered, but it still shows that there is a much bigger difference between EV/Revenue and EV/EBITDA for oil and gas companies than for renewable energy companies. This is because while oil giants tend to be heavily vertically integrated, they also often buy a lot of the oil they refine and sell. Given how long they keep this oil on their books, it hardly reduces their exposure to oil prices, but it does substantially increase their costs of goods sold. While the investment and maintenance needed to build an oil or gas well and a solar panel field are comparable, renewable energy companies do not trade on their raw material because it is free. This is why oil companies have relatively higher EV/EBITDA ratios and this is why multiples like Price/Sales and EV/Revenue are not the most relevant when comparing firms in different subsectors of the energy sector.

Both the renewable and traditional energy companies considered here are giants with complex and integrated business models which make it hard to determine exactly what multiples should be used to value them. Nevertheless, the business of companies like NextEra revolves around building and operating solar panels and wind turbines as well as the gridlines used to bring the energy they produce to where it is needed. The presence or not of adequate power grids can be an obstacle to the development of renewable energy infrastructure, which is why they tend to be integrated in green energy companies’ business models. Oil companies operate differently, with a longer process of upstream and downstream operations from oil exploration to retailing. These differences in the way these companies operate also explain why they are valued at such different multiples.

 

Conclusion

In conclusion, there does not seem to be a bubble in green energy stocks. Prices have been ever more increasing recently due to the growing enthusiasm among investors, but growth perspectives for renewable energy are such that valuing these stocks at such high multiples makes sense. As renewable energy stocks go up, traditional energy stocks go down, although it is hard to tell why. Short term investors have deserted them due to the low demand for oil and coal caused by the pandemic, and investors with a horizon of more than ten years see an ultimately limited growth. As news of a 90% effective vaccine brought hope of an early end to the pandemic, oil stocks have rebounded but are still underperforming green energy stocks. This recent difference in performance reflects markets’ better-late-than-never realisation that renewables will necessarily be the way energy is produced in the future rather than an inflation of green energy stock prices.

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