Some sectors are packed with rapidly growing companies. Energy typically isn’t one of them—but that doesn’t mean some energy companies don’t deserve a place in a quality-growth portfolio.
It may seem like an odd fit at first blush, given that earnings in the Energy sector are notoriously volatile. Commodity prices can swing wildly, which not only affects energy producers’ revenues but also influences how much oil or gas they choose to pump out of the ground. Shell, for example, has exceeded a cash flow return on investment of 5% only once in the past 15 years, and its earnings are projected to remain flat over the next five. Even so, there are compelling reasons to own the stock. Here are a few:
1. Geopolitical risk
Energy production is concentrated in politically unstable regions, and major disruptions can quickly shake global supply. Past shocks, from shipping interruptions in the Strait of Hormuz to sanctions on Russia, offer reminders of how fragile supply can be. These events tend to hit the stocks of long-duration growth companies hardest, as investors discount their distant earnings more heavily. Therefore, holding a large energy company such as Shell helps balance the risk. As a diversified producer, Shell has less direct exposure to any single risky region, and the company benefits when wars or sanctions push oil or gas prices higher, allowing it to sell its global production at elevated prices.
2. Inflation protection
Spikes in inflation also tend to weigh on traditional quality-growth sectors such as Consumer Discretionary or Information Technology, whereas Energy stocks have historically outperformed during those periods. (Of course, higher oil prices are sometimes the very source of the inflation.) Therefore, Energy holdings can provide idiosyncratic benefits during periods of shifting inflation and favorably alter the overall risk profile of a portfolio.
3. Positioning for supply shocks
Demand for energy tends to be steadier than supply, which shifts with new discoveries and reserve depletion. For diversified producers with large reserves, that dynamic can be favorable: when supply increases, they benefit from higher volumes, and when supply tightens, they benefit from higher prices. Shell is also the largest integrated player in energy trading. As a natural consequence of the energy transition, weather volatility, and geopolitical tensions, energy volatility is likely to increase and could remain elevated. Higher volatility increases opportunities for capturing outsized margins from trading, and Shell, with its insight into global energy markets and global footprint, is well-positioned to exploit those opportunities.
4. Investment flexibility, without style compromise
Exposure to the sector can help diversify sources of return. However, many energy companies fail our quality-growth screening due to high financial and operating leverage, which create elevated risks, and a history of financial weakness caused by the cyclicality of their end markets. Shell’s diverse, cost-advantaged portfolio has enabled it to generate more durable cash flows than its rivals. Recent operational momentum is also helping to bolster its financial strength; management is working to cut costs and focus on higher-return assets while selling weaker ones. These measures should improve operating margins and lift cash flow return on investment when commodity prices are favorable.
5. Sustainable growth in LNG
Given the volatile nature of earnings in the sector, forecasts should be taken with a grain of salt. They don’t adequately reflect Shell’s unparalleled scale and expertise in liquefied natural gas (LNG) and the long-term growth opportunity it provides, as coal-dependent economies, particularly in China and Southeast Asia, shift toward cleaner energy. With limited pipeline access and declining domestic gas production across much of Asia, LNG is the most practical lower-carbon fuel available. Global demand for LNG is estimated to rise more than 50% by 2040, and most scenarios point to a global supply shortfall emerging in the 2030s. By 2030, Shell plans to grow its LNG business by 20‒30% and its LNG liquefaction volumes by 25‒30% from 2022 levels. Moreover, with global energy demand set to grow alongside rising populations and living standards, Shell looks well positioned to meet that demand while evolving with the energy transition. ∎