[The global energy markets are under increasing strain due to the heightened risks from geopolitical actions, supply disruptions, and price volatility. Beyond this current reality, investing in the global energy markets offers great long-term growth potential for an investment portfolio. Capturing this opportunity, though, requires a deeper knowledge of the particular dynamics and complex drivers of the global energy marketplace.

To better understand the nature and potential strategies of investing in the global energy markets, we were introduced to Matthew C. Stephani, President of Cavanal Hill Investment Management and lead Portfolio Manager for the Cavanal Hill World Energy and Power Fund – a growth and income mutual fund, with multiple Lipper and Morningstar awards, investing in a wide range of energy-related financial instruments (stocks, bonds, ETFs, and other asset types related to energy) issued in the U.S. and markets around the world. The team pursues a differentiated strategy of seeking investment opportunities with attractive risk/return profiles, a strong margin of safety, the ability to capture market inefficiencies, and, interestingly, seeks to remove some cyclicality from the fund to capitalize on secular trends.]

 

Hortz: Can you give us a lay of the land of the scope and depth of the investable global energy market?

Stephani: If you look at the MSCI All Country World Index (ACWI) which covers approximately 85% of the global investable equity market, energy makes up about $4 trillion of that index. Traditional energy is two-thirds of that sleeve - integrated oil companies, oil field services, midstream companies, refining, and exploration/production companies. Another third, approximately, is solar, wind, hydrogen, critical minerals, and nuclear power. We also consider utilities and companies that produce equipment to generate electricity as part of that energy universe.

When we started this fund, we did not want to look at it just as a commodity-based fossil fuel fund. We wanted to go full spectrum from when you get something out of the ground - whether that is oil, gas, or uranium - to ultimately generating electricity. We wanted to be able to own anything in that supply chain, including electrical equipment, refiners, and nuclear power. That is our defined investable energy universe.

To fully quantify, $4 trillion of our investable universe is energy, another $2.5 trillion is utilities, and about $1.5 trillion is power equipment. In total, that represents about $8 trillion of investment opportunities out of the $104 trillion ACWI that we look at. We also consider special situations and emerging market opportunities that have either sponsored or unsponsored ADRs, providing access to U.S. liquidity.

Hortz: Why did you not want to be a typical energy commodity fund? Why did you make that decision to expand your investment universe?

Stephani: The reason for expanding the investable investment space for energy is that I have been in this business for more than 25 years. And in my experience, one of the most cyclical areas to invest in is fossil fuels or energy stocks because they are hypersensitive to the price of the commodity.

What tends to happen is that oil prices, which run up energy stocks, often lag. Investors see oil prices run up, they grab at rising energy stocks and tend to buy them all the way up. When the oil price breaks, the oil market starts selling off, and investors catch the downturn more often than they catch the upturn. So, our view from the very beginning was that, because energy is a hyper-cyclical market, we wanted to help take that cyclicality out for investors.

So, our business starts with an assessment of the oil and gas markets. And if our assessment of the oil and gas markets is that demand is overwhelming supply and we think that is positive for the commodity price, then we are long in the fossil fuel area. If we see the opposite, if we think that the signal in oil markets is likely that we are oversupplied, then we are spending more of our time and spending more of our investment dollars in the electricity generation and utilities portion of the portfolio, rather than the traditional fossil fuel investments.

That was an informed and practical decision we made 13 years ago when we launched the fund, because we did not want investors to have a bad experience with this fund due to that cyclicality trap. We wanted to help smooth the ride for our investors by broadening what we look at as an energy-related equity.

Hortz: Can you give us examples of how you remove cyclicality from an energy fund?

Stephani:  All stocks are cyclical, in my view. It is just that the cycles do not always match up. You can have a biotech cycle, an industrial equipment cycle, or a housing cycle. And if you have different stock cycles in the portfolio that you run, through careful portfolio construction, the cyclicality of one can take some cyclicality out of the other.

In other words, does the demand for natural gas turbines fluctuate based on the price of oil? Not really. If oil is cyclical and drives oil-related commodities up and down as a result, that is one cycle, but the demand for gas turbines is a separate and different cycle. We are just trying to buy stocks that do not all trade on the same cycle.

When you add natural gas transportation, electrical equipment manufacturers, natural gas turbines, and nuclear to a traditional oil and gas fund, you are adding businesses that are on a different cycle than the price of oil.

That is another reason why we focus on the macro growth areas in the energy space and determine how they relate to each other. We invest in those growth areas, with their different cyclicality timing, in a portfolio designed to potentially give our investors a ride that is a little smoother, but that takes advantage of the underlying economic dynamic that cheap energy is what drives economic growth and that the world’s demand for energy will continue to rise.

Hortz: What are the larger macrotrends in the global energy markets that are creating long-term investment opportunities for investors?

Stephani: There are numerous factors in both the fossil fuel side of the market and the electrical equipment side of the market that I think are developing into solid five-to-ten-year trends.

A big multi-year theme for us is moving natural gas around the world. Alternative energy policies in much of the world have created opportunities for increased solar and wind production, but that does not align well with data center demand, which is more 24/7, making natural gas a preferred option. We think we are in the middle innings of moving gas around the world. Right now, natural gas prices in the United States are $3, in Europe they are $14, and in Japan they are $17. Well, it takes about $3 to $4 to move that gas from the US, Australia, and Qatar (cheap places to produce natural gas) to those other regions. We are not necessarily focusing on the price of gas; it is just the volume. We are interested in who and how volumes of gas are being moved around the world to meet the power demand needs of other countries.

Equally important is the build-out of data centers. It has been since the 1870s that the United States has had 2% of GDP coming from capital spending in one sector, which was the rail industry. Now think about the benefit of that. For 150 years, we have benefited in the United States from having a massive rail industry that allows us to move goods across the country at a relatively low cost. I believe that data centers are the 21st-century rail system, and we are just starting to build them. And the gating factor on building data centers is not chips, it is not location, it is not even water, as much as it is power - to generate power for AI. Power is going to be the gating factor for who wins the data center build-out and which country dominates AI. And whoever dominates AI for the next 20 years is most likely to be the global economic leader.

Then there is the opportunity around the electrification of other segments of the economy and the electrical equipment that goes with it. That is important because, frankly, over the last 20 years, electricity demand in the United States has been relatively close to flat. What has happened is that a lot of the grid equipment has actually aged over that time. It has just been working, but it has not necessarily been a growth area, so it has not received the needed investment. But, because of the demand from data centers, which we feel is going to be exceptionally high, we think data centers will grow from about 5.5% of all the electricity consumed in the United States today to 12-13% in five years. To meet that demand, we have to expand the grid capacity as well. It is not just that we need gas turbines; we need a stronger, more resilient grid if we are going to move into this digital future. If we are going to build the digital railroad of the 21st century as we did in the 1900s or 1800s, we have to invest in the grid.

Hortz: Are there newer energy macrotrends that you see starting to form into long-term investment opportunities?

Stephani: A new one for us is Venezuela. We think the opportunity in Venezuela is significant and we like the service companies that can operate there, as well as the big integrated oil companies in the United States. We think the break-even in Venezuela is far lower than in the Permian Basin over time. Now it will take some time and capital investment in Venezuela to make that happen, but having been moved out of China’s sphere of influence towards the West, Venezuela becomes an additional source of "friendly country production" that the West can look to meet its oil needs. The assets in Venezuela are not only lower-cost assets, but also very strategic assets for the Western world and an interesting long-tailed investment opportunity.

Another newly forming trend, which we think has bipartisan support for the first time in my lifetime, is new nuclear power. We think new nuclear power is a multi-decade opportunity, not only in the United States, but particularly in both Western and Eastern Europe, as well as Southeast Asia. What we think is interesting here is that a significant portion of nuclear fuel used in the utility industry for the last several decades has been decommissioned warheads. We have not mined 100% of our uranium needs globally for many decades. So, we believe that prices have to rise in the uranium market to bring on additional production. Also driving nuclear into a long-term trend is the fact that it is very difficult and very expensive to run a data center with intermittent wind, solar, and battery options, versus the ability for nuclear reactors to produce near 100% capacity for years on end without downturns.

Hortz: How exactly do you factor in alternative energy sources like wind and solar?

Stephani: There is a place for wind and solar in our grid for sure. It matches some of our usage patterns very well. Think about solar. You build a solar farm and an office building next to each other. The sun comes up at six in the morning, and people start showing up at the office around seven or eight. People start leaving at five to six o'clock at night as the sun goes down around seven o'clock at night. You powered that building perfectly - your timing of when you were producing power at the solar farm and your timing of when your air conditioning, lighting, and computer demands in a building were matched perfectly.

We have seen great improvements in alternative energy technology, particularly in solar over the last 15 years. However, those products can add strain to the grid. Think about a natural gas plant that used to be a baseline provider of power and would run at 80 to 100% capacity all day and all night. And now you add solar to the mix. Now you have to throttle that gas plant on and off depending on the sun in the sky. That is harder on the equipment. Take any piece of equipment, you just turn it on and leave it running. It works pretty effectively. If you turn it on, turn it off, turn it on, turn it off, turn it on, you shorten the life of the product. That is what I think is happening with some of the equipment that is already on the grid. It is going to depreciate a little more quickly than what we would have expected had solar and wind not been added to the grid. But, we do continue to look at those alternative energy stocks and they are definitely in our investment universe and have been an important part of our portfolio in years past. I can tell you we do not have any because of the change in subsidies and we think resizing a business to react to changes in federal subsidies is often more difficult and takes a few more years.

The most effective answer to me is nuclear power. The problem is it takes eight to 10 years to build and nobody wants to be power plant number one. Everyone is in line for number five. Restarting our nuclear industry is actually going to require some level of federal support. And I think that support is very likely. In fact, there is $80 billion set aside for developing nuclear power in the United States. Both parties appear to be very favorable to nuclear.

Hortz: How do you integrate that global energy market view into your risk management and portfolio construction process? Can you give us some examples?

Stephani: Let me answer that question with a discussion of our process. Our process begins - because of the space that we are in and the dominant size of the oil market relative to every other market that we are looking at - it begins with our view of the oil markets. If we have a neutral view of the oil markets, we are likely to be fairly well invested in oil and fossil fuel-related stocks. Maybe that would be 65-75% of the portfolio. If we have a very positive view on oil, for example, supply is not meeting up with demand and we see a real difficulty in adding supply, we may have 75 to 85% of our investments in oil-related, fossil fuel equities. If we have a negative view on the price of oil, then we take that down to 30 to 50% in oil-related fossil fuel opportunities. That is our starting point on how much of this portfolio we want to have tilted towards fossil fuels?

Then it is a relative valuation and relative attractive growth rate to consider. We are looking at both the valuation of other subsectors, whether it is utilities, electrical equipment, nuclear power opportunities, and then the growth associated with each of those markets. So, in a time where we are neutral on the price of the commodity, maybe 25-35% is in these other energy sub-sectors. If we are negative on the commodity, it may be more like 50% of the portfolio and we also have the opportunity to use fixed income in this portfolio, per the prospectus.

When there is an energy sell-off or demand drying up, as in COVID, what we did is we had a significant portion of the portfolio in high-quality, energy-related fixed-income instruments to protect our investors, to protect our investments, while the supply and demand of the market got back to balance.

Hortz: How would you characterize where global energy investments fit in a client’s portfolio?

Stephani: The biggest challenge for anyone in retirement is making sure that you have enough assets and the growth in your assets keeps up with inflation that you experience once you are no longer working. One of the biggest sources of inflation historically has been rising oil and energy prices. Those can create shocks that get embedded into everyday purchases and prices. One way of hedging retirees against rising oil, gas, and electricity prices is to own an investment in the producers of oil, gas, and electricity.

Bottom line, we think investments in the energy sector fit very well in client portfolios as an inflation hedge. We also believe that the long-term growth in the sector is likely to be robust, especially in the larger long-term secular trends that we are focused on, such as data centers, the movement of gas around the world, nuclear power, and delivering new electrical equipment to help generate power for AI. We believe that energy is the literal keystone to future economic growth and prosperity.

We would recommend advisors work with their clients to get them focused away from the short-term distractions and global disruptions to the long-term investment case. The global energy market is in the early innings of a very big transformation as we transform both how we produce electricity and energy and what the new demand patterns are.

 

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Disclaimer: This interview is for informational purposes. Nothing contained herein constitutes investment advice or the recommendation of or the offer to sell or the solicitation of an offer to buy or invest in any specific investment product or service. Before investing, you should carefully consider the investment’s objectives, risks, charges, and expenses. This and other information can be obtained through https://cavanalhillfunds.com/mutual-funds/equity/world-energy-fund  and/or contacting your investment advisor. Please read the prospectus and other investment documents carefully before you invest. Investing involves risk, including the possible loss of principal.

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