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Why Fossil Fuels Aren't Dead Yet

By Brian Perry - Dec 28, 2020 at 7:28AM

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Even as renewable energy prices plummet, gas and oil's appealing yields and positive supply/demand dynamics make for an attractive investment opportunity.

The shift toward clean energy is leading some investors to question future demand for fossil fuels -- but contrarians might find that this is the time to invest in the sector. According to BP, 84% of the world's energy needs are still met by fossil fuels, which means that even if usage declines, demand will remain enormous. Clean energy might be the future, but fossil fuels are the present. 

Oil derrick and barrel of oil on table of money

Image Source: Getty Images

Demand and supply

Consider again that fossil fuels still provide 84% of the world's energy needs. All of the world's planes fly on fossil fuel. How long would it take to retire all the current planes and replace them with say, solar-powered planes? How much money would that cost an industry that's already decimated by the pandemic?

The vast majority of the world's cars are gasoline-powered. And even California, perhaps the most progressive state, has allotted a decade and a half before mandating that in 2035 all new car sales will have to be from zero-emission vehicles.

The cost of solar and wind power has declined by more than two-thirds in the past decade, making them an increasingly attractive energy source. But even aggressive proposals for the shuttering of coal plants forecast a rather lengthy 15-year transition period. And while coal seems to be on a slow decline, natural gas remains popular. In 2019, a third of all newly constructed U.S. power plants were powered by natural gas. 

In other words, even if the world wanted to abandon fossil fuels, doing so would take many decades. But in all likelihood, the whole world does not, in fact, want to move to clean energy. Consider this: The energy sector is responsible for 10% of the Canadian economy, as measured by gross domestic product (GDP.) In Saudi Arabia, that share is even higher; 50% of GDP comes from oil and gas. Russia is the world's second-largest natural gas producer, and the third-largest producer of oil. Do these countries want the world to move away from fossil fuels? Probably not.  

Structural demand for fossil fuels provides intermediate-term support. In the shorter run, the International Energy Agency estimates that the pandemic reduced global energy demand by 5%. While fallout from COVID-19 will likely be felt for several more years, effective vaccines should eventually lead to a resumption of "normal" work, leisure, and travel, which could lead to higher energy demand. And that increased demand would occur right at a time when supply is shrinking.

Last spring's price collapse and COVID-related demand declines resulted in 35 North American energy producers declaring bankruptcy in just the second and third quarters of 2020, which will reduce future supply. And the OPEC+ organization, which represents a combination OPEC and non-OPEC oil-producing nations (such as Russia), recently lowered its planned 2021 oil supply increase from 2 million barrels per day to 0.5 million barrels per day.  These future supply reductions will likely help support prices as demand recovers.

Getting paid to wait

Even if the price of energy stocks stagnates in the near term, investors in some cases are getting paid well to wait. Beaten-down prices combined with steady dividend payouts have resulted in especially high dividend yields.

Between 2015 and the end of 2019, the dividend yield on Exxon ( XOM -0.64% ) fluctuated between 3.4% and 5%. Early in 2020, that yield jumped to 5.8%, and today it stands at 8.35%. Chevron currently yields ( CVX -0.63% ) 6.03%, after bouncing between 3.5% and 5% during the previous five years. Looking abroad, BP ( BP -0.55% ) is yielding 6.11%, and Royal Dutch Shell ( RDS.A -0.66% ) yields a lower, but still attractive, 3.78%. 

Of course, if energy prices and profits remain low, there is no guarantee that companies will be able to maintain their current dividend payments. Over the past decade, Exxon has only covered 67% of its dividend payments through free cash flow. For Chevron, that number is 52%, and for BP 25%. Shell is the comparative "winner," but even there only 80% of dividends have been covered by free cash flow. The remainder of shareholder payouts have come from borrowing, asset sales, or reductions in cash reserves. And those figures only cover the period through 2019. The impact of the pandemic will only exacerbate the challenges these companies have faced in the past decade. 

But given the essential role energy, and energy companies, play in the global economy, it seems unlikely the sector will disappear anytime soon. If you have the opportunity to collect a few fat dividend checks from stocks in a sector with attractive short-term supply and demand characteristics, why wouldn't you do so?

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis – even one of our own – helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.

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Stocks Mentioned

Royal Dutch Shell plc Stock Quote
Royal Dutch Shell plc
RDS.A
$43.58 (-0.66%) $0.29
Exxon Mobil Corporation Stock Quote
Exxon Mobil Corporation
XOM
$60.89 (-0.64%) $0.39
Chevron Corporation Stock Quote
Chevron Corporation
CVX
$114.41 (-0.63%) $0.73
BP p.l.c. Stock Quote
BP p.l.c.
BP
$26.91 (-0.55%) $0.15
BP p.l.c. Stock Quote
BP p.l.c.
BP
$340.85 (1.26%) $4.25

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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