Oil is unlikely to be a good investment » Yale Climate Connections

When we think about solving climate change, sometimes the specter of oil’s dominance in our economy can seem overwhelming.

But what if the production of oil and methane gas – commonly called natural gas – aren’t quite the dominant businesses they once were?

Despite recent record profits, the industry is predicting weaknesses in potential growth, with implications for investors broadly, not just those of us who care about solving climate change.

Fossil fuel energy’s performance in review

The above chart shows the 10-year returns of the energy sector, largely consisting of oil and methane gas, as of October 31, 2024.

For all the clamoring about whether fossil fuels should be divested from an ethical standpoint, it’s important to look at whether it’s been a good investment from a financial standpoint.

How have energy investments performed?

Consider the financial performance of energy investments on a few timescales.

Over the last 10 years, investment in energy has returned a paltry 0.61% annually to investors, compared to the SP 500’s 10.95%, as of November 1, 2024.

The key reason for that lower rate of return has been the drop in crude oil prices in the 2010s, sparked by various factors like cheap U.S. fracked oil, OPEC dropping prices to undermine fracked oil, slowing demand from China, and of course, competition from renewables.

Wind, solar, and batteries are scaling exponentially and eating into oil’s market share, according to the nonprofit RMI and energy expert Nat Bullard.

If you look at the three-year price performance, energy generated larger financial returns than stocks and bonds as a whole, returning 16.02% annually, as of November 1, 2024. Energy performed particularly well in 2022. But past performance is no guarantee of future returns, so it’s important to investigate if oil’s one-year surge in 2022 is actually a newly emerging trend or if it’s just a cyclic jolt from Russia invading Ukraine and the resulting decreasing oil supply.

In the past year, energy investments have faltered quite a bit, returning only 4.48% to the broader SP500’s 36.04% one-year return, as of November 1, 2024.

Signs of weakness

A more forward-looking indicator is the 2017 peak in sales of internal combustion engine cars, one of oil’s largest markets. Although cars stay on the road for years, the oil industry would ideally want to see a growing demand now to count on growing demand later.

That’s not what’s happening.

Estimates of future oil demand vary widely.

One good source of projections is Resources for the Future, a U.S. nonprofit that conducts independent research into environmental, energy, and natural resource issues. The organization’s 2024 Global Energy Outlook reviews several of those projections. Notably, none anticipate an exponential growth of oil – not even the rosiest outlooks from ExxonMobil and Shell.

Possibilities for future growth

It’s conceivable that the oil and methane gas business could grow in response to increased demand for electricity generation from AI data centers, crypto mining, and EVs. But at the moment, only 6% of oil is used for electricity. And 85% of newly added electricity capacity in 2023 was renewable.

Beyond electricity generation demand increasing, what other pathways do the oil and methane gas businesses have to scale exponentially?

Oil and gas need to innovate because the projected demand of their primary business is expected to plateau.

One place they could do that is in carbon capture and storage – removing carbon dioxide from their air and storing it, often underground. It’s an expensive business, but newly available tax credits under the Inflation Reduction Act could help.

But fundamentally, the pickle the industry is in is that its leaders want to use carbon capture and storage for enhanced oil recovery, which involves injecting carbon dioxide under depleted oil or gas reservoirs to squeeze out more production.

That’s not really a new line of business, it’s just creating a more sustainable version of the existing business. And that’s unlikely to exponentially expand.

It’s hard to know for sure what the long-term impact of competition from renewables will be. The oil and gas industry might hold steady or decline deeply.

But no one thinks that it is going to scale exponentially from here on out, and that’s what you’re looking to find in investment returns.

And we have a precedent for what happens to investments when a major energy source plateaus: the case of coal. Check out its investment performance between 2010 and 2021.

That is a precipitous drop!

My view is that oil won’t have as stark a decline in performance as coal because oil is used in many more applications than coal, such as heavy-duty transportation (trucks, airlines, shipping, etc.), light transportation (cars), industrial processes (cement, steel, paper), and chemical manufacturing. But investors may flee when they don’t see exponential growth.

On the other hand, if you’re looking for exponentially scaling businesses, consider low- and lower-carbon energy sources.

Check out how fast solar and wind are scaling in the visual above, pulled from Our World in Data.

Renewables are expensive to build but cost very little to maintain, or what is technically known as a high cap-ex to low op-ex business. Construction requires a loan up front, and the higher the interest rates, the higher the payments. So it’s noteworthy that the growth above has happened even in the face of rising interest rates.

Key takeaways

Knowing all this, you can develop a three-part investment strategy.

Conclusion one: Oil demand, even in the rosiest scenario, is unlikely to grow much. So maybe don’t invest there?

Conclusion two: Renewables and climate solutions are exponentially scaling. So maybe invest a bit more there.

And three: Some business models can exist through this energy transition. Think of companies like Costco, Apple, Meta, and Microsoft. So there is value in keeping those for diversification and the fact they may last.

In other words, you can build a portfolio by remembering this simple rhyme: divest, reinvest, hold the rest.

Breene Murphy is the president of Carbon Collective Investing, a climate investment adviser for employer 401(k)/403(b)s, individuals, and institutional investors. Murphy is a Grist 2024 Top 50 Climate Leader, and Carbon Collective Investing is an implementation partner of Project Drawdown and a CEO for Electrification with Rewiring America.

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