Alternative Investment: Energy (5 of 8)

Alternative Investment: Energy (5 of 8)

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Energy has been a long standing classic defensive investment, with success dependent on actively managed funds, regular portfolio rebalancing and diversification, but drivers for investment such as renewables are starting to change the landscape

Risk Level

'Energy' is Risk Level 5 of 8 in Alternative Investments.

Investment Case

Peak Oil

It is not just oil – all reserves of fossil fuels are dwindling. According to oil giant BP, (at the current price and level of technology, globally) we have just 46 years of oil reserves left, 58 years of gas and 118 years of coal. Activities such as extracting oil from tar sands or deepwater drilling are becoming more commonplace, but are also more dangerous and expensive – witness the £24billion cost to BP of the Deepwater Horizon disaster in the Gulf of Mexico.

Global Demand

Supply is reducing while demand is growing, partly driven by the growth of China - which accounted for over 70% of the growth in consumption in 2011 - along with India and other emerging markets, according to the International Energy Agency. Oil company Shell estimates energy demand will double by 2050.

There have also been some short-term surprises with both upsides and downsides. These have included a new shale gas ‘bonanza’ in the US and the recent withdrawal of support for nuclear power after the Fukushima disaster in Japan. The contraction of supply and increase in demand is likely to have a profound effect on availability and push up prices of fuels across the globe. Companies that can benefit from this will be attractive investments.

Environmental Concerns And Opportunities

As well as being non-renewable, fossil fuels are also pollutants that contribute towards climate change. Half of all global carbon emissions have occurred since the mid 1970s according to the Carbon Dioxide Information Analysis Centre, and governments are seeking to legislate to reduce pollution.

As part of the Kyoto Protocol in 1997 a target was set that 20% of energy should come from renewable sources by 2020. The UK, EU and many other governments signed up to this commitment, although both the US and China were notable abstainers. Nevertheless, the search for clean, renewable sources of energy to replace fossil fuels continues to drive new investment, and this is an emerging sector where the alternative investment industry has taken notice.

Findings

Most products in this sector began life in 2011 and 2012, so it is a relatively new and immature market for alternative investments.

Two of the best known renewable energy sources – hydro-power from hydroelectric dams and wind power from wind farms – do not have any significant retail investment opportunities attached to them. These are large-scale infrastructure projects that require considerable capital injections over long periods so are usually funded by governments, hedge funds and institutional finance.

There is a clear split in the sector between projects based around solar energy and projects based around biofuel or ‘green oil’. Solar projects tend to be located in developed countries with higher minimum investment levels, more counter-parties involved (including lawyers, trustees and developers) and are more likely to be structured using an SPV or a bond. They are typically promoted to high net worth and sophisticated investors but some products have been marketed to retail investors.

Annual returns from solar initiatives are projecting returns of 8 to 12% a year, with terms ranging from 5 to 25 years.

Biofuel projects are often located in emerging markets with tropical climates to aid production; they offer lower minimum levels of investment, fewer counter-parties and a broader range of ownership structures, including direct ownership via a lease, bond and/or loan arrangements. Biofuel projects tend to begin with comparatively low annual returns - around 4% a year - that increase as the crop matures and eventually reach a high of 17% a year. The investment terms typically average 10 years but can range from anything between 3 to 45 years. The exit strategy is not always clearly defined and investors should look carefully at the terms and conditions before they commit to a product.

There has been a notable failure amongst Biofuel investments - a Cambodian based Jatropha project is currently being investigated by the Serious Fraud Office with an estimated £34 million worth of investor funds at risk.

There are also a small number of projects based around investments in small-scale oil and gas exploration and extraction. These are held in regulated collective structures such as Enterprise Investment Schemes (EIS) or offshore SPVs and are usually targeted at high net worth and sophisticated investors. The more speculative investments aim for high returns in the region of 20 to 30% a year.

Investors in any of these projects have to investigate the product provider and operating companies experience and in some solar projects the trustees, developers and other counter-parties require investigation. Investors and agents not only have to satisfy themselves the companies involved have the capabilities to develop the projects, but they also need confidence there will be a market for the end product.

Alternative energy is still a relatively new industry and continues to face stiff competition from traditional fossil fuels for market share.

Summary

Energy has long been a classic ‘defensive’ investment sector but the growing interest in renewable energy is creating new and interesting investment opportunities. Some of these are accessible through both directly held and collective investment structures. The alternative investment products researched in this area offer a wide range of options; from heavily regulated and more speculative collective investment schemes aimed at the more sophisticated end of the market, to lower entry level direct ownership investments.

Investment Fundamentals

  • Dwindling fossil fuels
  • Need for renewable energy
  • Located in both developed and undeveloped countries
  • Has been fraud in the industry
  • Can be many parties involved

Investor Conclusions

The biofuel products in this sector may appeal to those who have concerns about the environment, but investors and their agents need to be thorough in order to pick out high quality operators that can deliver on their investment promises. It is a market that can attract opportunists, where decisions are based upon the availability of cheap land in emerging market locations rather than a desire to develop a new industry. However, there are also some notable exceptions, with some solar and oil projects based in more developed locations.

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