How are higher commodity prices and shipping disruption affecting the energy transition sector?

We believe the long-term investment case for the companies exposed to the energy transition investment theme remains unquestionably positive. Government policy support and investment visibility are increasing substantially almost by the day.

Investors’ interest in this space continues to be very strong. Given the recent and healthy pullback in share prices, we also feel that the risk reward trade-off has improved considerably over the last few months.

However, even with this significantly improved outlook, we are ‘slightly cautious’. We are aware of some potential headwinds and therefore risks facing the energy transition space right now. These headwinds are not specific to the energy transition sector, but definitely worth mentioning.

Equity investing is always subject to ongoing external risks such as broader market equity valuations and volatility, and internal risks such as company specific execution. But at this point in time, inflation and its impact on input cost and supply chain management is definitely one of the biggest external headwinds facing all industries right now. We are not expecting the energy transition space to be immune.

Commodity price rises will be felt across energy transition space

Take a company that provides electrical equipment, or wind turbines, or even fuel cell stacks: all of these companies are exposed to rising steel, aluminium or copper prices.

The recent price increases in commodities have been unprecedented, in terms of the magnitude and speed of the increase. These price rises are happening in metals, agriculture and energy prices. As far as we can tell, pent-up demand has partly been a driver of these price increases (implying that it is transient), but also supply constraints have been exposed, due to years of under-investment (implying that it is structural).

Past Performance is not a guide to future performance and may not be repeated.

There are already differing views on how sustained these inflationary pressures will become. For example, Jerome Powell (the Federal Reserve chairman) believes that these inflationary pressures are short term and transient in nature, and that the recent data is likely to prove “a blip during the reopening post pandemic”. Whereas, in contrast, some economists are highlighting more ‘structural’ risks and that the inflationary data could pick up over the next 6–18 months.

While we are not trying to second guess Mr Powell, we do fear that some of the lesser known economists could prove correct, at least for the remainder of this year, as the commodity exposure and rising cost pressures do not stop there.

Shipping disruption poses further inflation risk

The energy transition investment theme is very much global in nature and the majority of companies have global supply chains. This means many companies have exposure to both shipping rates and goods transportation logistics management.

In response to a supply surge between 2007 and 2012, the shipping industry has essentially endured a long period of under-investment in order to wind down excess inventory, to the point where there is very little flexibility left in the system. Put simply, the disruption in the global container shipping industry shows no sign of being resolved quickly and could lead to shortages in almost all products until the end of the year.

China is at the hub of global shipping and the recent outbreak of Covid-19 (again) at major ports in the Guangdong province has caused acute congestion at the region's ports. Many of the terminals are effectively operating at a fraction of their normal capacity. This adds to the problems for shipping firms that have been struggling to cope with dramatic fluctuations in demand triggered by the pandemic, as well as the consequences from the recent blockage of the Ever Given container ship in the Suez Canal.

These combined disruptions have resulted in the rates, for all classes of ship used for goods transportation, increasing significantly in price over the last 12 months, as the chart below shows.

Past Performance is not a guide to future performance and may not be repeated.

Industry participants believe that the disruption will continue for at least another 12 months, with consumers in Europe and North America in particular continuing to face much longer lead times than normal for their goods. They also note that many purchasers are locking into longer-term shipping contracts (12–36 months) at below current prices, but significantly above prices 12 months ago. These higher transportation costs have to be absorbed by someone.

Robust long-term prospects for energy transition investing

For context, we are not at all bearish on the outlook for energy transition equities. The prospects for cashflow growth over the next three, five and ten years are clear and we have recently seen a healthy retracement in equity prices.

Although investors tend to think long term, they should be aware of and factor in near-term earnings risks. This is particularly the case in companies that are trading on very high near-term multiples, where there is no room for disappointment.

These near-term headwinds should be seen as a risk. We fully expect the share price volatility of individual companies and associated sub-sectors to increase over the next few months, as management teams update the market with the overall impact of these logistical and inflationary pressures.

But for investors who, like us, take a long-term view on investing, rest assured we will take advantage of this near-term volatility to increase exposure in really good companies at really good valuation levels.

The returns profile of these companies may suffer some short-term pressures, but overall we think the trend is firmly upward.