November Newsletter: The Heat Is On

16 November 2021

As COP26 runs its course the world faces an energy crisis. Gas prices have risen 10-fold in some parts leaving governments subsidising fossil fuels as households and industries plea for help to pay bills. Meanwhile as China’s energy consumption threatens black outs, more coal is burned than at any time in history. Whatever is decided at COP26, has the horse not already bolted? There must be a silver lining to this climate cloud? Well, high energy prices help bring about the green revolution and we are getting those. But even more positively this fuel crisis has been caused by the markets radically changing something called the Cost of Capital.

The cost of what? ‘The Cost of Capital’ is the financing costs a company must pay when borrowing money or using equity finance to fund a big project or investment. The cost of borrowing we can understand as most of us are familiar with mortgages on a house. The cost of equity finance is a bit trickier. But let us look at it by taking the dividend yield on a share. For example, if you buy shares in the oil company BP you can expect to receive a dividend each year. At BP’s current share price that dividend equates to a 5% return on your investment, a 5% yield. Tesla on the other hand does not pay a dividend at all. Put simply, the cost for BP’s equity financing is 5% and Tesla’s is zero.

At COP26 the world’s largest 140 finance companies have signed up to the green agenda too. That means less borrowing will be available for fossil fuel development and what borrowing there is will be at a higher price. So, while BP profits from the current fuel crisis the cost of capital has broken the cycle of reinvesting those profits into more oil wells. BP’s profits are going into windfarms instead!! Higher oil prices mean more windfarms…

These extreme changes in the cost of capital are creating domino effects. Big changes in where money is invested are creating a short supply in one area and an abundance in another. Gas shortages for instance have sent fertiliser prices up from $100 a tonne to $1,000 a tonne. This threatens next year’s crop yields as farmers cannot afford to fertlise their land. People will go hungry.

For you the investor, it is a choice of where you want your money to work. If you are struggling to stop yourself jetting off on holiday but worry about the planet you could see investing in ‘green’ stocks as a sort of carbon offset. But isn’t investing about returns? So, shouldn’t we be investing in oil companies now? Probably is the answer. But as the cost of capital continues to climb the markets will de-rate (push down the value) of any oil stock that continues to reinvest their profits into more oil wells. Oil stocks are cheap on normal valuations but until the management of those companies grasp the fact that their profits need to be invested outside of the oil industry, they will remain overlooked by the market.

As for COP26 it may seem like the same old inaction but make no mistake it has further increased the cost of capital for the polluters of the world. The markets are working as our collective conscience while we plan that holiday abroad.

Kind Regards
Craig Harper
Mole Valley Asset Management