Bet On Energy Resilience
In the coming recession, it will be critical to your wealth
The S&P 500 Energy Index returned nearly 65 percent including dividends in 2022. That was in a year when the S&P 500 lost -18 percent, and energy bettered the Nasdaq 100 by almost 100 percentage points.
As of April 20, weightings for the four main technology subgroups—software, computers, Internet and semiconductors—were a combined 33.1 percent of the S&P 500. They were also four of the top five sectors, the other being pharmaceuticals. In contrast, oil and gas was the 8th largest group at just 4 percent.
That adds up to big future losses for investors who’ve based their portfolios on S&P 500-focused investment plans, or index ETFs like SPDR S&P 500 ETF Trust (NYSE: SPY).
Simply, the economy is slowing. Recession risk is rising. And the root cause--relentless pressure from the Federal Reserve on the financial system—shows absolutely no sign of letting up.
A little over a year ago, the Fed Funds rate was basically zero. Next month, the Fed will likely take that benchmark over 5 percent, the fastest rate of increase since the 1980s. And based on public statements from several voting members of the Federal Open Market Committee, there are likely to be more rate hikes over the summer.
The Fed Funds futures market is still pricing in meaningfully lower rates in the next 12 months. The problem is at last count CPI inflation was running at 5 percent, versus a central bank target of just 2 percent. That makes it far more likely any drop in Fed Funds to that level will be the result of a recession, rather than a central bank victory over inflation.
Worse, nothing the Fed is doing now addresses the powerful long-term forces stirring inflation, including a decade of underinvestment in oil and gas production and related infrastructure. In fact, a year of rising borrowing costs and recession risk to oil and gas prices is depressing industry CAPEX needed to increase supply.
Most of our top energy stock recommendations in www.energyandincomeadvisor.com will be releasing Q1 earnings and update guidance in the last week of April/first week of May timeframe. But based on what we’ve seen so far, 2023 is shaping up as yet another year of modest CAPEX and subdued production volumes.
Leading North American midstream company Kinder Morgan reported 2.7 percent higher natural gas pipeline volumes in Q1 over year ago levels. But it also posted an -11 percent drop in diesel throughput at its refined products pipelines, as well as -5.4 percent less crude oil and condensate.
Kinder’s ability to self-fund its operations—relying on the capital market solely for debt refinancing—is the best possible sign the company is positioned to weather a recession this year. Another is the modest 2 percent dividend increase effective with next month’s payment.
That’s not the case for every energy company in North America. Equitrans Midstream, for example, appears to be closer than ever to a dividend cut, with its stock priced to yield more than 12 percent. This month, a federal court threw out yet another previously granted permit for the 303-mile Mountain Valley Pipeline, putting a project representing 40 percent of the company’s shareholders equity on life support.
But best in class North American producers, midstream and downstream energy companies are now well adapted to lean times. Investment plans, dividends and balance sheets are therefore insulated from a Federal Reserve-induced recession. And the CEO of Baker Hughes—a global oil and gas field services leader and also early reporter of Q1 results—states the current “spending cycle is more durable and less sensitive to commodity prices” than any in recent memory.
Given all that evidence of business resilience, it’s fair to ask why Wall Street money managers are still underweighting energy stocks.
It’s hard to call following a playbook that’s worked since the 1980s “recency bias.” But with rare exceptions most current big money managers didn’t start their careers before the 2000s. And many have been trained to disregard market history in an age of algorithmic trading, artificial intelligence and ETF dominance.
The result is a blind spot of epic proportions.
Mainly, since the 1980s, economic downturns have brought down oil and gas prices hard by quelling demand, even as supply remained plentiful. And energy stocks have crashed as a result—for example the -40 percent plus decline in the S&P 500 Energy Index over roughly six months following the late 2008 fall of Lehman Brothers.
But in the decade before that—the 1970s—energy prices and sector stocks were consistently resilient in the face of economic downturns. And when the economy cycled out, best in class companies always emerged on higher ground.
Contrary to popular myth, the Federal Reserve of the 1970s didn’t pull any punches when it came to fighting inflation. From July 1971 through July 1974, it pushed Fed Funds from 4 to 13 percent. And from August 1977 through May of 1981—the Volcker Fed—the rate went from 4.75 to 20 percent.
The 1970s, however, were basically one long bull market for oil and oil stocks. Fed efforts to corral inflation temporarily depressed demand. But discouraging investment actually worsened the supply squeeze at the root of rising energy prices and resulting inflation.
And that’s basically where we are now: A decade of under investment in oil and gas made worse by ongoing actions of the inflation-fighting Fed, even as underlying demand continues to grow.
To be sure, continuing rapid adoption of renewable energy will help well-placed companies and consumers avoid much of the impact. NextEra Energy, for example, projects hundreds of millions of dollars of fuel cost savings for its customers in coming years, just from swapping out fossil fuels for solar at its south Florida utility.
But even under the most optimistic projections for renewable energy, current International Energy Agency World Energy Outlook projections have fossil fuels supplying 62 percent of global energy demand in 2050. And factoring in 2.8 percent annual global energy demand growth, usage will continue to grow despite declining market share.
Sooner or later, all commodity upcycles come to an end. Prices rise for so long that everyone forgets they can fall—just as the down cycle of the previous decade convinced many investors oil and gas will never return even to highs of the previous decade.
Eventually, higher prices encourage over-investment, adoption of alternatives and conservation that creates more supply than demand. And at that point, commodities and stocks drop.
That’s about 180 degrees distant from the reality of spring 2023. Investors who aren’t afraid to buck Wall Street’s “recency bias” will lock in historic upside with best in class energy stocks—and they’ll dodge the worst of an increasingly likely recession and stock market downturn later this year as well.