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BlackRock Energy and Resources Income benefits from traditional energy holdings

BlackRock Energy and Resources Income (BERI) has announced its results for the year ended 30 November 2021, during which it provided NAV and share price total returns of 34.4% and 41.7% respectively. In comparison, the EMIX Global Mining Index rose by 12.5% and the MSCI World Energy Index rose by 41.2% over the same period. BERI also holds around 30% of its portfolio in energy transition stocks. To give this some context, the S&P Global Clean Energy Index rose by 1.4% over the year ended 30 November 2021, while the WilderHill Clean Energy Index fell by 6.1% (all percentages in Sterling terms with dividends reinvested). Following a dismal 2020, energy was the top-performing global sector (+28.6%1) through the last financial year. Oil prices were up more than 50% on average year-over-year. However, BERI’s managers comment that the market moves seen during November mean that its results carry a rather different set of numbers and tone to what was envisaged at the end of October. They say that oil prices falling by over 20% in a month are a sharp reminder of the need to maintain a balanced and risk-aware portfolio as well as to retain some dry powder to take advantage of corrections that occur even within strong long-term uptrends.

BERI says that, despite the challenges faced by equity markets as a result of COVID-19, its income from investments remained robust. The revenue return for the year to 30 November 2021 was 4.96 pence per share, a 15.1% increase compared to the prior year earnings per share of 4.31 pence. The level of revenue generated is such that the minimum dividend that BERI must pay out to maintain its investment trust status has exceeded the 4.00p per share target set by the Board in January 2021. As a result, the Board announced in December 2021 that it would pay a fourth quarterly dividend for the year to 30 November 2021 of 1.10 pence per share (making the total dividend payment for the year of 4.10 pence per share). BERI’s board also said that it would increase the trust’s annual dividend target to 4.40p per share for the year to 30 November 2022.

Manager’s comments on portfolio activity and investment performance

“Portfolio activity in the second half of the year has focused on a couple of key areas. First, we were quite active in the traditional energy sector during the second half of the year. As can be seen in the portfolio positioning chart included on page 11 of the Annual Report for the year ended 30 November 2021, we increased our energy exposure through to July and then pared it back as we thought markets had got ahead of themselves. We did this by trimming the traditional energy position as a whole and rotating some of the holdings within the energy sector. During the last few months, we increased the exposure, with a gas bias, as we saw global gas markets tightening rapidly with inventories in Europe lower than seasonal averages.

“Secondly, we made changes within the mining sector to reflect the risks we saw to the steel-making commodities because of the slowdown in the Chinese property sector. We reduced our iron ore holdings and added to more base metal exposed companies such as Glencore, which was trading at an attractive free cashflow yield and has a trading business that should benefit from the ongoing logistics/supply chain challenges and price volatility. We also added two steel companies to the portfolio as the combination of China restricting exports, lack of new capacity in Europe/US, and upcoming green infrastructure spend should see higher margins persist for longer than current valuations imply.

“Finally, within the energy transition sector we were focused on identifying holdings that could be vulnerable to margin compression in an environment of input cost inflation and also those that are more interest rate sensitive.

“This resulted in positions such as a wind turbine manufacturer being reduced in the portfolio, and towards the end of the year we saw several announcements from companies in this space warning of sharply high costs and lower margins for 2022. Although we remain excited about the long-term growth prospects across many enablers and adopters of decarbonisation, we had a greater proportion of the portfolio invested in mining and traditional energy for most of the year as we judged the investment opportunities to be more compelling from a valuation and risk-adjusted perspective.

“Overall the Company had a strong year of returns, generating 34.4% overall (2020: 13.9%).”

Manager’s comments on income

“The trend of improving returns back to shareholders in the traditional energy and mining sectors continued apace during 2021. Record dividends were paid by a number of large mining companies in addition to share buybacks in several cases. Encouragingly, the companies enacting such moves have also continued to strengthen their balance sheets and the overall financial health of the companies is very strong relative to their own history.

“Perhaps the most significant positive surprise on the income side during the year was the step up in shareholder returns from the traditional energy companies. This came not only from the integrated oil majors (e.g. Chevron, which delivered a modest dividend increase) but importantly from the Exploration and Production (E&P) sector. The shift to a better balance between reinvestment and shareholder distributions is very welcome with companies such as Devon Energy increasing its regular dividend as well as announcing a series of special dividends.

“In terms of option income, 2021 saw the continuation of our recent trend of a lower proportion of income coming from option writing. Option premiums accounted for just over 10% of gross income for the year, down from around 25% in 2020 and even higher levels in 2015-18. We will be opportunistic in our approach to option writing – we were active at the end of 2020 in selling puts as we saw strong upside on economic recovery across the energy markets but did very little in the middle part of the year as volatility dropped and selling options became less attractive.

“It should also be noted that 2021 saw the Company return to a more normal position of a tax expense, compared to 2020 where we benefitted from an extraordinary gain on a substantial tax refund.”

Manager’s comments on Traditional Energy

“Following a dismal 2020, energy was the top-performing global sector (+28.6%1) through the last financial year. Oil prices were up more than 50% on average year-over-year.

“Last year we outlined our belief that the energy sector was entering a new era, one characterised by better capital allocation and increasing returns to shareholders. For a sector that has been synonymous with poor capital returns for decades, scepticism was warranted particularly as oil prices tracked a steady recovery throughout the year. Yet, quite remarkably, the US shale companies are on pace to reinvest less than 60% of their internally generated cash flows this year. This is in stark contrast to the ten years ending 2019, where the sector reinvested as much as 150% of each dollar generated. By mid-year, industry balance sheets were largely repaired and cash returns to shareholders inflected dramatically.

“At this point it is probably worth asking what has changed in the oil and gas sector. Historically, this was a sector perennially incentivised to chase double-digit top line growth that predictably led to oversupply and the inevitable boom-bust cycles. Now, shareholders are being promised double-digit returns comprised of high single-digit cash returns supplemented by low single-digit, profitable, volume growth. This discipline is what differentiates the current situation from previous cycles.

“It should be noted that the Organisation of the Petroleum Exporting Countries (OPEC) and supporting countries (OPEC-plus) have continued to exhibit similar discipline in managing supply/ demand imbalances since the global pandemic kicked off in earnest in March 2020. Whilst oil markets were initially unsettled by the news OPEC-plus would commence adding back up to 400,000 barrels per day each month from August 2021, the group has continued to moderate its plans to accommodate the fragile recovery in underlying demand.

“Not surprisingly, stock prices of E&P companies outpaced the broader energy market and this was an area where the portfolio was positioned strongly for most of the year. In contrast, this discipline proved less helpful for the Oilfield Services (OFS) companies which continued to struggle with over-capacity across most service lines and a reluctance among oil companies to increase budgets.

“Reflecting back on last year’s expectation that the industry was entering a new era of discipline, it was clear that this would benefit a strong oil price recovery. However, the less obvious effect of discipline in oil was discipline in natural gas. With fewer oil wells being drilled, this meant lower associated natural gas volumes. Coupled with a regulatory reluctance to sanction new pipelines in North America, the decade-long bear market in natural gas prices is firmly over. This prompted a deliberate shift towards high quality North American natural gas producers within the portfolio.

“The era of the shareholder is characterised by stringent capital allocation. This fiscal prudence is being reinforced by investors, yet is set against a consumer unwilling to make the tough decisions towards faster decarbonisation. Many pundits continue to focus myopically on forecasting peak oil demand (which we view as inevitable), yet singularly fail to recognise that we passed peak investment seven years ago.

“That we need to continue apace to bend the carbon emissions curve downwards if we are to hit Net Zero is a given. Sadly, policy makers and consumers continue to apply the majority of their focus towards supply-side reductions. With little heed paid to bending down the demand side curve, this mismatch may continue to keep commodity prices high for many years to come.

“The underinvestment in oil and natural gas coincided with a sharp restart in the global economy. Colder northern hemisphere temperatures at both ends of the year have tightened gas markets in Europe and Asia as demand for heating surged and renewable intermittency reared its head. Political tensions between Russia and the European Union (EU) have undoubtedly played a hand in driving up natural gas and power prices to record highs this year.

“The surge in US natural gas prices this year paled in comparison to the record highs experienced in Europe and Asia where spot markers breached $40/mmbtu through October. Record high gas prices also left their mark on carbon markets with the European Emissions Trading Scheme (ETS) price hitting a record €75/t (US$85/t) during November. Whilst the bifurcation in gas prices between North America and the rest of the world can be partially explained by political tensions between the EU and Russia, the primary driver remains underinvestment in our opinion. Recognising these dislocations, we positioned the Company towards those companies in a position to supply Europe with natural gas.

“We continue to believe that natural gas (ultimately coupled with carbon removal) is a critical bridging fuel to a lower carbon world. On the one hand, many parts of Europe are looking to shut down baseload nuclear capacity. On the other hand, rapid deployment of renewables means we need natural gas to help deal with intermittency (the sun does not always shine and the wind does not always blow). Frustratingly, policy makers in some countries are not approving responsibly-managed domestic gas projects that could alleviate the emerging supply/demand imbalance. The losers in this scenario are those that can least afford record high energy prices today.”

Manager’s comments on Energy Transition

“When we first introduced Energy Transition stocks into the Company in May 2020, we had a clear and simple view: the path to Net Zero would not be a straight line and hence a balanced and nimble approach was warranted. Solving for Net Zero requires a complete replumbing of our global energy system – and energy transitions of this scale are measured in decades rather than months. Just as important is that they require efforts from all stakeholders. The good news so far is that capital markets and industry have made good progress with more companies outlining credible plans to hit Net Zero and the underlying economics of wind and solar continue to make enormous strides. Yet, as outlined earlier, consumers and policy makers are not reacting as swiftly nor with any visible cohesion. It was perhaps a little unsurprising then that COP26 in Glasgow this year ended with little in the way of significant progress.

“On a more positive note, the long-term prospects for stocks embracing the Energy Transition continue to brighten with the US$1.75 trillion “build it back better” US bill gaining initial House of Representatives approval in November. This came shortly after the EU approved its Green Deal in May.

“Rapidly rising European natural gas and power prices throughout the second half of the year have seen a swift reaction from several governments to cap retail prices ahead of winter. The burden of this cost is to a large extent being borne by European utility companies and as a result we cut the Company’s exposure during the period. We tilted these funds towards key suppliers of natural gas to Europe.

“The other notable issue for Energy Transition stocks this year has been that of tightening global supply chains causing inflationary pressures. Despite the strong long-term outlook for renewables, this cost inflation overwhelmed the wind and solar manufacturers causing sharp underperformance. We have reduced exposure to both sectors in anticipation of continued inflationary pressures. Although inflationary issues are expected to persist into next year, we do view them as transitory. However, as more and more economies look to “reshore” their supply chains and manufacturing capabilities we see scope for inflationary headwinds to become a longer dated feature.

“Ironically, inflation resulting from “reshoring” is being compounded by higher energy prices which in turn are forcing many industries to pursue more aggressively energy efficient investments. This bodes well for companies exposed to areas such as building insulation, heat pumps and industrial efficiency equipment and monitoring.”

Manager’s comments on Mining

“After a great first half of 2021, the second half of the year was decidedly worse with a few mined commodity prices delivering modest positive returns but most of them falling from their mid-year highs. The long-term demand support for many metals that will come from the investment into decarbonisation of power, transport etc. will be positive but the last six months have been a timely reminder of the importance of China as the world’s largest consumer of metals.

“The most notable feature of the second half of the year was the significant fall in Chinese steel production. For October and November, steel production rates were down 15-20% compared to the same months in the previous year. For context, oil demand in the US and Europe fell by a similar amount during the widespread lockdowns of April 2020. The contraction in steel production was initially prompted by environmental and power curbs as shortages of power and spiking energy prices caused authorities in China to look to reduce the output of power intensive industries. This was then compounded by a pronounced slowdown in steel demand from real estate/construction in China. Property tightening measures had already slowed demand and then the financial difficulties experienced by a well-known developer appear to have caused another air-pocket in demand. However just as Western central banks are starting to tighten monetary conditions, we have seen the first signs of easing in China and expect this to continue in the first part of 2022. This should be supportive of a pickup in demand for steelmaking materials, for example iron ore, and their prices.

“Over the course of 2021, there have been a number of political events that have refocused the market on the challenges of maintaining current mine supply, in addition to incentivising investment into new capacity. The elections in Peru in the first half of the year were heavily focused on the mining industry and the eventual winner was the leftist candidate Pedro Castillo. Whilst his populist rhetoric during his campaign has yet to be translated into negative legislation for the industry, it has almost certainly deterred capital investment into new mining projects. Peru is the world’s second largest copper producer so disruption to future production by delaying or cancelling investment is likely to support medium-term copper prices. Similar threats face the world’s largest copper producer, Chile, where the Senate recently pushed forward discussion on increasing royalties/ taxes on mining. This would also impact the outlook for future lithium supply as Chile produces over a fifth of the world’s current lithium and sits on some of the largest undeveloped reserves globally.

“The mining companies remain in an extremely strong financial position and the theme of capital discipline/ shareholder returns that we have written about in a number of previous reports remains well intact. The charts set out on page 16 of the Annual report for the year ended 30 November 2021 show the strength of balance sheets in the mining sector compared to other sectors as well as the attractive dividend yield relative to broader equity markets.”

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