Lexicon Financial Group Weekly Update — October 9, 2024

Oct. 9

“Fire made us human, fossil fuels made us modern, but now we need a new fire that makes us safe, secure, healthy and durable.”

— .Amory Bloch Lovins, an American writer and physicist who has written on energy policy and related areas for four decades

From the desk of Craig Swistun, CIM, MFA-P, Portfolio Manager, Raymond James Investment Counsel, and Wayne Hendry, Client Relationship Manager, Raymond James Investment Counsel

Looking Around

The content for each weekly update often starts with a question or comment made during conversations with clients and readers. Recently, we were asked about the benefits of investing in the oil and gas sector, so this week, we’ve decided to take a closer look.

Oil dominates every aspect of our lives. It fuels our cars. It is used in the production of plastic goods. It provides electricity for our homes and factories. It’s even found in the fertiliser for the soil that grows our food.

Before investing in any sector, we need to understand how that sector relates to the overall economy. Like all good stories, we want to start at the beginning.

Some of the earliest civilisations relied heavily on oil. For example, crude oil that had bubbled to the surface was used by the Babylonians – modern-day Iraqis – to waterproof their boats and as mortar in building construction. The Egyptians also used oil in the preparation of mummies to help preserve corpses.

The oil industry, as we know it today, began in the mid-19th century with the discovery of the world’s first commercially viable oil well in the United States (U.S.). Emerging technology created new products such as kerosene (for lighting homes) made from oil.

The first commercial oil well in the U.S. was created at Titusville, Pennsylvania, when a new technique was pioneered using a pipeline to line the boreholes to allow deeper drilling. The success of the well, plus a growing demand for kerosene, triggered an oil rush that ultimately led to the creation of a major new industry. Oil was also discovered and developed early in Canada. Where do you think the town of Petrolia in Ontario got its name?

Demand for oil accelerated, in part due to the invention of the motor car by German engineer Karl Benz in 1885. His machines ran on a cheap by-product of the kerosene production process called gasoline. As car ownership grew, so did the demand for oil, to make the gasoline that was used as fuel. At this time, oil was discovered in the Middle East and Western companies secured oil exploration and extraction rights for a relative pittance. Over time, Middle Eastern oil production would develop to provide over 60 per cent of the world’s supply. By the way, as of 2023, the U.S. is the world’s largest producer of oil, outpacing Saudi Arabia, Venezuela, and even Russia. (1)

Two world wars, several crises (including the Suez Canal crisis, the 1973 oil embargo, the 2015 oil price collapse), the invention of extraction techniques like fracking and more than a few regional conflicts later, oil remains essential to modern-day life. Just look at the graphic below to see what is made from one barrel of oil.

Given this, anyone would believe that investing in oil equities or the oil sector would be a smart and rewarding move. The researchers at the Institute for Energy Economics and Financial Analysis (IEEFA) do not share this belief. They found that, across the board, an investment of US$10,000 saw both markedly weaker growth and higher risk in investments that included fossil fuels, over five- and 10-year periods.

Even taking into account an energy crisis and a surge in prices following the Russian invasion of Ukraine, the researchers discovered that dropping oil, gas and coal stocks from portfolios proved a winning investment strategy in the medium and long term. Recent decades have seen a rapid decline in fortunes for the fossil fuel sector, which, in 1980, made up about 30 per cent of the weight of the S&P 500, but now stands at just 3.9 per cent. The researchers found that the energy sector trailed the performance of the S&P 500 in eight of the 10 years between 2012 and 2021 and placed dead last in five of those years.

How did this happen?

Well, according to these researchers, much of the optimism pinned on fossil fuels in recent years has been attached not to their stability, but to their volatility, depending on unpredictable crises and bad actors to deliver shocks to the system. Growing competition from less volatile and cheaper renewable energy sources have possibly led hydrocarbon producers to find it increasingly difficult to offer managed shareholder value. Furthermore, a growing assortment of material risks — from physical risk in the form of increased flooding, to legal risk from the rising tide of climate litigation worldwide — are making the long-term prospects for oil, coal and gas investments even bleaker.

While acknowledging that "past results are no guarantee of future outcomes," the IEEFA sounded a further warning to investors still weighing the pros and cons of oil, gas and coal: the disruption and destabilisation in fossil fuel commodity markets, competition from renewable energy, the electrification of transport, and growing investor consciousness of climate change’s financial risks are driving other investors to re-evaluate fossil fuels’ place in their portfolio. According to the IEEFA, this will play out as a collision between economies of the past and the future and the fossil fuel sector may not be prepared to manage the challenges of the coming decades. (2)

That doesn’t mean that oil and gas – or the companies that produce them – are bad long-term investments. Indeed, traditional oil companies themselves have grown more diversified and are often at the forefront of the green energy revolution. They know that they need to move beyond reliance on a single commodity to create stability for their investors. Diversification, it seems, is popular even in the oil patch.

If you would like to find out more about this, please contact us by email or just call us.

Read and Watch

Want deeper insight into topics in your Weekly Update? Then, read and/or right click:

Middle East conflict: How will it end?

Europe’s economy survived ‘terrible prophecies’ but must now tackle trade with China: EU’s Gentiloni

China stock rally fizzles as stimulus news disappoints

Raymond James Markets & Investing: The U.S. economy is on track for a soft landing – CIO Larry Adam, October 4, 2024

Raymond James Economy & Policy: September data seems to show economy rebounding - Chief Economist Eugenio Alemán, October 4, 2024

Looking Back

Speaking of oil, at the end of last week, Canada’s commodity-linked main stock, the Toronto Stock Exchange S&P/TSX composite index (TSX), rose to a record high on Friday as the “black gold” extended its sharp gains and a blowout U.S. employment report alleviated concern about a slowdown in the American economy. The technology sector also rose two per cent. Financials ended up 0.9 per cent last Friday, while the energy sector added 1.3 per cent and was up 8.5 per cent for the week - its biggest weekly advance since October 2022. The Canadian economy often tracks the oil and gas sector, leading some to controversially refer to our currency as a petrocurrency.

The Dow posted a record closing high on Friday and the Nasdaq ended with a more than one per cent gain as a stronger-than-expected jobs report calmed investors who had worried the U.S. economy may be getting too weak. U.S. job gains increased in September by the most in six months as the unemployment rate fell to 4.1 per cent. These gains have led to traders further reducing bets on a 50-basis-point reduction at the Federal Reserve’s meeting on November 6 and 7. They are now pricing in just an eight per cent chance of a 50-bps rate cut, down from around 31 per cent, according to the CME Group’s FedWatch Tool. (3)

However, the prospect of a wider war in the Middle East is what sent oil prices to their highest level in about a month. The retaliatory ballistic missile attack against Israel by Iran rattled markets but they stabilized later because the worst-case scenarios failed to materialize.

Major equity markets in Europe ended lower last week. The pan-European STOXX Europe 600 Index ended 1.80 per cent lower as an escalation of conflicts in the Middle East made investors cautious. There may be some light at the end of the tunnel here, as comments from European Central Bank’s (ECB) officials indicated that their gradualist approach to easing monetary policy may be shifting. ECB President Christine Lagarde actually hinted that borrowing costs might soon be lowered, which may mean more interest rate cuts on the horizon.

Japan’s stock markets suffered sharp losses around the start of the week, as investors digested the country’s latest political developments. Shigeru Ishiba won the Liberal Democratic Party’s (LDP’s) closely contested leadership election on Friday, September 27, making him Japan’s new prime minister (PM). His monetary policy views are considered slightly hawkish, leading the yen to initially strengthen, and sending stock markets lower. While Japanese markets recouped some of the lost ground, they still ended down for the week.

Chinese stocks surged in a holiday-shortened week, thanks to optimism about the Chinese government’s comprehensive support measures offsetting disappointing data. However, China’s factory activity contracted for the fifth consecutive month amid weak demand. The value of new home sales by China’s top 100 developers fell 37.7 per cent in September from a year ago, accelerating from August’s 26.8 per cent drop, according to the China Real Estate Information Corp. Market sentiment appeared to improve after three of China’s largest cities relaxed homebuying restrictions on the back of the central government’s extensive stimulus package. (4)

The opinions expressed are those of Craig Swistun and not necessarily those of Raymond James Investment Counsel which is a subsidiary of Raymond James Ltd. Statistics and factual data and other information presented are from sources believed to be reliable, but their accuracy cannot be guaranteed. It is furnished on the basis and understanding that Raymond James is to be under no liability whatsoever in respect thereof. It is for information purposes only and is not to be construed as an offer or solicitation for the sale or purchase of securities. Raymond James advisors are not tax advisors, and we recommend that clients seek independent advice from a professional advisor on tax-related matters.