Avoid the Subprime Oil Bubble in Your Portfolio

I may not be able to change your mind about global warming or climate change. I will, however, lay out the economic case on why divesting from fossil fuel companies makes a world of sense.

If you are investing for the long term (i.e., the next ten years or more), you should divest. Fossil fuel companies are sinking ships, and you don’t want to be the last person on the Titanic.

I’ll show you how this can become a major advantage in your portfolio, even if sustainable, socially responsible investing (SRI), impact, or green investing isn’t your thing.

I’ve always believed that the key to solving global warming and the climate crisis lies in innovation and technology. Let’s face it: when given a choice between an inconvenient green option or an easy one, most people will opt for the easy, less expensive route.

I lived in San Francisco for many years and knew people who didn’t recycle because it required an extra bin. And that’s in San Francisco, where recycling is mandated by law!

Oil companies are facing challenges from every direction, not just from alternative energies.

Over the past decade, new drilling technologies have made oil and natural gas more abundant than ever before. This has massively increased the supply and, in return, has lowered the price of the fossil fuels still in the ground.

This hasn’t boded well for the major oil companies. The wildcatters and small outfits have been able to take away market share from what used to be only a few players ten years ago.

The US now has more access to domestic oil and natural gas than ever before. OPEC, the middle eastern oil cartel, is not nearly as powerful or effective at setting prices as it was ten years ago. 

Even though there has been a glut of supply, the other major factor that isn’t talked about is the exponential rise of renewable energy technology.

Unlike fossil fuel prices, wind and solar energy prices are based on the power of technology and are not directly tied to the economic forces of supply and demand.

What does this mean? Well, exponential technologies are deceptive. They start out slowly, but as they compound, they gain speed.

Ray Kurzweil, one of the best predictors of new technologies, famously said that when an exponential technology is at 1% immersion, it is already halfway to 100%. Solar and wind energy are already at 1%.

Think about the evolution of computing power over the past 20 years, and overlay that same progress with solar and wind power. Alternative energy started slowly, but it is gaining speed every year.

In fact, over the past seven years, the price of solar energy has come down a whopping 70%. 

Grid parity is the magic behind the demise of fossil fuel. Once reached, there is no turning back. Grid parity means that the cost of using alternative energy sources is equal to or less than the fossil fuel equivalent.

In third world countries, this is already true because they don’t have their infrastructure built like in the developed world. Consider cell phones: back in the 80s, they were status symbols for the elite, but now they are ubiquitous across the world.

There are now more cell phones than people. Because the cell phone technology was already cheaper, the third world never needed to install landlines, thereby leapfrogging the expensive infrastructure required for landlines.

Check out the TED Talk above outlining how alternative energy is already having a massive impact.

The horse has already left the barn. Energy storage technologies are also gaining steam.

However, one of the biggest challenges with solar and wind power is storing the power, and a recent coal campaign claimed the sun doesn’t always shine and the wind doesn’t always blow.

This is true, but even this intermittency problem is being solved by increasing the efficiency of batteries.

The cost of battery storage has dropped off a cliff, and when you have a lot of smart people trying to solve a problem, it’s not a great idea to bet against them. Investing in fossil fuel companies is a pessimistic bet against innovation and technology. 

The big question is when the energy sector will start to decline. When should you divest? The answer is yesterday.

The energy sector dominated by fossil fuel has been on a downward spiral since the 1980s. According to Standard & Poors, the energy sector was 28% of the total market cap of the S&P 500 in 1980. Fast forward to 2017, and it is now under 10%. 

Over the past five years, the energy sector has returned a measly 1.9%, while the S&P 500 has enjoyed an annualized return of close to 15%. The energy sector is barely keeping up with inflation!

You are taking on a whole lot of risk if you invest in the fossil fuel energy sector: over the past ten years, the sector has had a standard deviation of 21%, compared to the S&P 500 at 14%. This means that the fossil fuel energy sector has been 50% more volatile than the market. It doesn’t take a hedge fund manager to figure out that this is a very bad trade-off! 

Fossil fuel companies have already destroyed value in your portfolio if you buy index funds. The S&P 500 and the Vanguard Total Market both have about 6% invested directly in the energy sector with more companies that have indirect exposure through the industrials and basic materials sectors.

Why isn’t this already priced into the market? Well, the markets aren’t 100% efficient.

As I mentioned earlier, exponential growth is deceptive. Investors look at advances in a linear fashion.

In fact, the US Department of Energy puts out a report each year predicting the market share of renewable energy, and its predictions have been notoriously wrong. Jigar Shah, a leading innovator in solar power, has pointed this out time and time again. 

According to Shah, the Department of Energy predicted in 2010 that solar would produce .45 gigawatts of power on the grid by 2035. Just three years later in November 2013, the US surpassed that number by 16 times! The Department has wildly low-balled the growth in renewables every single year. 

The other major factor is that indexing has gained momentum over the past decade. Indexing refers to blindly buying companies that are part of an index, such as the S&P 500.

This has consequences. When trillions of dollars flow into these funds, the market and the companies that make up the indices get propped up. They get a free ride in the form of the index funds buying the outstanding float of the company.

This is great for Chevron and Exxon Mobil: since they are already big, they have massive buying pressure on their stock through these index funds. This has artificially inflated the value of these companies. 

What could be the final stake in the heart of energy companies? Electric transportation.

The trend away from internal combustion engines is accelerating. Major European countries and India have ambitious plans to ban the use of ICE engines over the next decade, and every major auto company now has a fully electric vehicle in its lineup.

Tesla has just rolled out the new, affordable Model 3. What would happen if electric cars grabbed 10% of market share over the next five years? That alone would put massive downward pressure on the demand of oil.

In the short term, who knows what will happen to the fossil fuel energy sector. Last year, it rallied after the November election to be the top performing sector in 2016.

The performance over the next year of energy or technology or any other sector is unpredictable, but I firmly believe that, over the long run, it will be a costly mistake to bet on fossil fuel.

As an investment advisor and fiduciary, I have taken the pledge to always act in my clients’ best interests and therefore believe that it is imperative to avoid fossil fuel companies that have destroyed shareholder value.

My firm, Impact Fiduciary, is proud to have no equity exposure to fossil fuel companies. If you are a financial advisor, I’d be more than happy to share my strategy and how I’ve gone to great lengths to avoid fossil fuel companies while employing a smart, low-cost strategy.

If you are an individual looking to take control of your financial life, I invite you to schedule an appointment with me.

Together we can craft a long-term financial plan to help you realize your vision while investing in a better world. 

Disclaimer: This article is provided for general information and illustration purposes only. Nothing contained in the material constitutes tax advice, a recommendation for purchase or sale of any security, or investment advisory services. I encourage you to consult a financial planner, accountant, and/or legal counsel for advice specific to your situation. Reproduction of this material is prohibited without written permission from Patrick Dinan, and all rights are reserved.