Energy ETFs face a low-carbon future

This article appears in the March 2022 issue of Advisor’s Edge magazine. Subscribe to the print edition, read the digital edition or read the articles online.

The S&P/TSX Capped Energy Index was up 95.1% for the year ending Feb. 28, 2022, but its 10-year compound return was effectively zero. However, with Brent crude oil over US$110 a barrel, Russian exports and supply chains constrained, economies rebounding and energy at 13.4% of the Canadian equities market, investors who lack exposure are underperforming.

Investing in oil and gas with established production offers predictable margins and profitability as demand for power continues to grow. But much noise surrounds the industry.

The Caisse de dépôt et placement du Québec, most Canadian universities and many religious organizations are among 1,500 institutions representing almost $40 trillion in assets that have committed to purge some or all carbon emitters from portfolios, according to the Global Fossil Fuels Commitments Database. But will divestment change corporate behaviour?

Divestment shifts ownership to investors less concerned about emissions, while any chance to influence managements via proxy voting is lost. If share prices fall or the cost of capital rises, private debt and value investors always step up. Divestment is not like a boycott, which creates actual economic pressure; it’s about appearing to be ESG-aware rather than effecting change.

Planet-friendly power sources should eventually overtake carbon-based ones as higher oil and gas prices make more technologies viable. Integrated producers are already adjusting capital spending plans to diversify their prospects. Upstream expenditures that should be booming, given oil’s current strength, have been modest. At the same time, Canada’s energy sector has become more concentrated — and thus riskier.

ETF options

Should investors avoid energy altogether and/or participate in potentially sustainable technologies with their inherent risks?

Holding a broad index ETF captures both the performance from energy and the diversification from energy’s increasingly uncorrelated returns. Although Canada’s 13.4% energy weight versus the S&P 500’s 3.6% has penalized long-term performance, active managers have underperformed both indexes over time, so passive exposure is better. Here are three ways to address a low-carbon future.

• Long position in an S&P/TSX composite or S&P/TSX 60 ETF and short the energy index or a leveraged oil or natural gas ETF: eliminates energy exposure but captures the benefit from volatility that erodes compounded sector returns.
• Long position in a higher-cost, ranked ESG ETF with energy exposure: offers energy participation plus engagement potential.
• Long position in a broad market ETF and long Horizons’ or Ninepoint’s carbon credit ETFs, which are based on the future price of carbon credits: correlated with oil prices, the credits will track demand to offset carbon emissions and could be an elegant way to capitalize on industrial success (reduced supply of credits) and failure (higher credit prices to meet targets).

Traditional oil and gas businesses may end up like tobacco: highly profitable with attractive dividends but shunned by ESG investors. Exploiting new opportunities in power will be important for the Canadian energy sector’s survival, so watch for alternative approaches in new ETFs.

Table 1: TSX-listed energy and commodity (shaded) ETFs

*Management fee only

Mark Yamada is president of PÜR Investing Inc., a software development firm specializing in risk management and defined contribution pension strategies.

Mark Yamada

Investments

Mark Yamada is president of PÜR Investing Inc., a software development firm specializing in risk management and defined contribution pension strategies.