Switching on to global energy investment

Increasing demand for energy combined with limited supply sounds like the perfect investment equation. However, as Mark Hume explains, it’s not without some risk.

As populations rise, economies strengthen and living standards improve, the long-term demand for energy is expected to increase.

The trajectory of rising energy consumption is likely to be dictated by the pace of economic growth and demographics in emerging markets.

Many of these countries, which are relatively low energy consumers today, are likely to see their demand for energy rapidly accelerate.

Meeting this future demand presents a major challenge that requires a cohesive and stable global energy policy, which draws upon all sources of energy supply.

If sufficient capital is not encouraged to flow into the global energy industry, the underlying growth capacity of the global economy could be constrained. 

A number of recent events have highlighted the persistent risks that face the energy industry.

The global financial crisis of 2008, the Macondo oil spill in the US Gulf of Mexico in 2010, the political contagion that swept through Africa and the Middle East, and the devastating earthquakes witnessed in Japan earlier this year are just some recent examples.

These risks are extremely difficult to accurately forecast and their consequences are equally difficult to quantify. It is this situation that highlights the importance of portfolio diversification: not just at the country level, or by commodity, but by company as well.

Demanding times

More people with more money tend to consume more energy.

Since 1970 the world’s population has almost doubled to seven billion people and the world’s primary energy demand has risen 120 per cent. By 2050, the global population is forecast to increase by up to four billion people (see figure 1). 

The level of global urbanisation is also expected to rise from 50 per cent today to around 70 per cent by 2050. In India and China alone, more than 300 million people are forecast to move from rural to urban areas over the next two decades.

Put another way, the world’s energy industry will need to accommodate the urbanisation of a country the size of the US.

The energy challenge

The scale of the future energy challenge is perhaps best illustrated by the disparity in energy use and population levels between the US, China and India. 

In 2010, the US consumed 19 per cent of the world’s primary energy despite making up only 4 per cent of the world’s population. By contrast, China and India combined consumed 24 per cent of the world’s primary energy, while comprising 37 per cent of the global population (see figure 2). 

Developing economies

Economic growth in developed economies has slowed in recent years – a situation which is allowing developing countries to rapidly close the income gap in absolute terms.

As relative wealth in developing countries rises, so does the increase in energy intensity.

Increasing populations, wealth and urbanisation drove primary energy consumption levels in developing countries past those of their more developed counterparts in absolute terms for the first time in 2009 – a trend which continued during 2010.

These structural changes will have important implications for global energy supply – not least from a competitive perspective as less developed economies seek to diversify their own energy sources both domestically and internationally. In short, geopolitical relations will play an increasingly important role in shaping the future path of energy demand and economic prosperity.

Earthquakes, oil spills and politics

Despite increasing demand and limited supply, navigating global energy markets is not without risk.

With virtually all of the world’s spare crude oil capacity located across Africa and the Middle East, crude oil prices rose dramatically following the political contagion that swept through the region earlier this year. Geopolitics has been, and will remain, a central risk to the energy industry.

Furthermore, with two-thirds of the world’s oil reserves located in predominantly Muslim countries and two-thirds of the world’s oil consumed in predominantly Christian societies, religion could also amplify future supply risks.

Up until the tragic events at the Fukushima nuclear power plant in Japan, nuclear energy was expected to play an important role in meeting future energy demand while shifting to a lower carbon footprint.

The resulting uncertainty in the nuclear industry, most recently with Germany announcing it will phase out nuclear power by 2022, has caused a significant share price reaction in many nuclear-related stocks.

Although this will almost certainly lead to a slowdown in new capacity construction, it is expected that nuclear power will play an important role in meeting the world’s longer term energy needs.

However, nuclear energy will only form part of the solution. Meeting the world’s energy needs will require input from all energy sources and so commodity diversification remains key.

Operational risk is also an important factor to consider and even large,  well-diversified companies can be exposed to significant and unpredictable risks.

At its worst, BP’s market capitalisation fell by almost one hundred billion US dollars following the Macondo well blowout in 2010. Diversification and risks cross more than just geographic boundaries and commodity prices.

Supply vs. demand 

The global energy industry faces significant and persistent challenges.

On one hand, the long-term outlook for primary energy consumption remains robust, anchored on economic growth, urbanisation and population growth, particularly from emerging markets. If left unchecked, the current supply options will struggle to keep pace with underlying consumption growth, which is already being felt in global oil markets.

On the other hand, from a supply perspective there is no silver bullet. Nuclear energy remains under a cloud following the tragic events at the Fukushima nuclear reactor in Japan.

Geopolitical risk across Africa and the Middle East has unmasked the fragility in global oil markets and their ability to cope with resurgent demand. Furthermore, the BP-operated Macondo well blowout underlines the significant risks that are taken by the industry on a day-to-day basis.  

In short, risks are prevalent and often unpredictable across the global energy industry, despite the supply and demand fundamentals.

Navigating these challenges can be fraught with risk but can be mitigated through appropriate diversification across a high quality global portfolio of investments.

Mark Hume is a senior equities analyst in Colonial First State Global Asset Management’s global resources team.