How investors can benefit from the upcoming changes in the energy sector

Renewable energy is expanding amid concerns about climate change. This presents an opportunity for investors. At the same time, traditional oil and gas production is also growing. So that’s an option too, although those concerned about reducing carbon emissions would probably skip it.

As Michael Cembalest, president of market and investment strategy at JP Morgan Asset and Wealth Management, put it in a recent article, the United States and the rest of the world are moving toward decarbonization, but that doesn’t mean fossil fuel investment is over. He noted that the world’s growing population means that demand for energy, especially traditional energy, is also growing.

“The share of fossil fuels in global energy consumption is falling by ~0.40% per year as the transition to renewable energy sources continues,” he wrote. However, “global CO2 emissions have not fallen because energy use has continued to rise; it is the share of primary energy from fossil fuels that is falling, not its level.”

The world is moving toward “electrification of everything,” he noted, such as home heating, which is now mostly done with fossil fuels. “The reason: If you can electrify something, you can eventually decarbonize it with wind, solar and storage,” he explained.

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That said, he continued: “While this transition is underway, it will take time because of the chemistry, physics, costs, human behavior and politics.” Coal use is declining, but the share of natural gas (which emits carbon, although less than coal) is growing. A large amount of gas will be used to power electrification. Since 2018, gas use has been growing by an average of 4% per year. As Cembalest put it, “it is hard to imagine the current prosperity of humanity without the significant contribution of natural gas.”

The world’s largest renewable energy companies—NextEra Energy Inc. (US), Vestas Wind Systems AS (Denmark) and Brookfield Renewable Partners LP (US)—have all seen strong stock growth over the past five years, averaging about 11% per year. At the same time, the fossil fuel industry has seen comparable stock gains: oil and gas giant Exxon Mobil Corp., for example, has seen its stock rise 11.8% per year over the same period.

Regardless, valuation multiples are below the market average (the S&P 500 price-to-earnings ratio is 24), with traditional fossil fuel providers standing behind renewables. Oil and gas prices were low for several years due to the pandemic, and now oil is recovering, although gas lags amid abundant supplies of both commodities. Exxon’s P/E is 14 and NextEra’s is 19.

Cembalest wrote that “energy sector valuation multiples remain low due to concerns about asset risk and the extent to which some institutional investors are unable or unwilling to invest in the sector.” Asset risk refers to concerns that oil and gas will become so unpopular that its value will be destroyed—an unlikely scenario, Cembalest said. Meanwhile, numerous university endowments and public pension plans are divesting their holdings in oil and gas stocks.