The gas crisis in the UK shows what can happen when hope triumphs over reality and major investment decisions are made for sub-economic reasons, according to RWC’s Ian Lance.
However, he said this also opened opportunities for investors who remained focused on the bottom line.
The cost of gas for suppliers has increased by more than 250% since the start of the year, caused by a combination of short-term factors: a cold winter last year which depleted global gas reserves, a fire at a National Grid site in Kent, and the shutdown of three nuclear reactors in the UK for maintenance. As a result, gas-fired power plants have had to run more often.
Source: ICE, Bloomberg, the BBC
However, longer-term structural issues have also played a part, such as the accelerated phase-out of coal; a greater reliance on wind power, which has suffered from unusually low wind speeds; and a decline in the number of gas storage sites.
Lance, who runs the Temple Bar Investment Trust along with Nick Purves, said the latter problems could be indirectly blamed on the rise of ESG (environmental, social and governance) investing and the move to divest from oil & gas.
“Fund managers are selling energy companies and are saying they are not going to hold them anymore for environmental reasons,” he explained.
“Over the weekend, for example, Harvard University’s endowment announced it is no longer going to invest in energy companies.
“But the point is that funds are forced to divest huge amounts of assets and take capital out of the industry. That's what we're seeing going on with energy prices, because we have not invested in gas for so long.
“We thought we would be fine relying on Russia and France and so on. Now it turns out we're not. We have paid the penalty and energy prices are spiking significantly higher.”
Purves added: “We would all like to move to a zero-carbon future tomorrow. The cold reality right now is that the technology is not there and the infrastructure is not there at the price that everyone needs.”
Lance said that while he can understand why investors are selling out of oil & gas companies, the “sub-economic” reason for their unpopularity meant he could pick them up on free cash-flow yields of 15 to 17%, adding “that's pretty interesting to us”.
Lance and Purves take a value approach to investing, thinking about potential holdings in terms of how they can benefit from the three main sources of returns: dividends, dividend growth and a share price re-rating.
With an oil & gas company, this means making a reasonable long-term assumption of $50 to $60 for a barrel of Brent crude. This includes a healthy margin of safety: the current price is $75.
“If you take BP,” Purves continued, “with Brent at $60 a barrel, it is paying a 5% dividend yield and has said it will deliver 4% per annum growth, so that is a 9% annual return. Then if the company is successful in putting together a reasonable level of dividend growth, the market might say to itself ‘that shouldn't be a 5% dividend yield anymore, that should be 4%’, so that is a 20% re-rating to add to your total return.”
A drawback with Lance and Purves’ approach is that while a stock may look like good value now, it relies on the assumption that the managers will be able to sell it on to someone who still sees value in it once they have held it for long enough for their hypothesis to play out. This may be a problem in an area such as oil & gas where the future looks uncertain.
In a recent article published on Trustnet, independent financial think-tank Carbon Tracker warned the exponential acceleration in the take-up of renewable energy meant that the fossil-fuel industry would not decline steadily: it was more likely to experience a similar fate to canals and telegrams, which became obsolete almost overnight.
However, Purves disputed this, saying that while no one knew whether demand for gas would be higher or lower in 10 years’ time, he would “bet quite heavily it would be higher”.
“We've made a very successful move away from coal to gas in the UK,” he said. “We generate very little electricity through coal now and that's enabled us to cut our carbon emissions.
“But we've got one hell of a long way to go in the developing countries of the world, and in some cases it hasn't really started.
“Yes, it is right to ask if these businesses have a long-term future. But on the current oil price, BP, Chevron and Total are all on P/Es [price to earnings] of 7X, meaning you're getting your investment back by 2030.
“So you would have to believe these businesses are disappearing very, very quickly,” he finished.
Data from FE Analytics shows the Temple Bar Investment Trust has made 50.4% since Lance and Purves took charge in November last year, compared with gains of 45.6% from the IT UK Equity Income sector and 30.5% from the FTSE All Share.
Performance of trust vs sector and index under managers
Source: FE Analytics
The trust is yielding 3.5% and has ongoing charges of 0.6%.
It is on a discount of 9.2% compared with 6.7% and 5.7% from its one- and three-year averages.