Pent-Up Energy

April 27, 2018

3 minute read

by Eric Knutzen, CIO, Multi-Asset Class, Neuberger Berman

Late-cycle support and attractive valuations could release the potential of commodity stocks.

Markets have gotten headline fatigue. Perhaps, to use my colleague Brad Tank’s terms, there is a point at which the noise becomes so cacophonous that it is simply easier on the ears to listen only for the signals.

Whatever the reason, while each day brings some new distraction, over recent trading sessions equity investors have begun to focus on corporate earnings. Those earnings signals have continued to show strength in the global economy.

Important signals are not, however, restricted to bottom-up company fundamentals. For Brad, the Federal Reserve and the European Central Bank are sending out the important ones. Similarly, I have described why we are intently focused on inflation expectations, interest rates and U.S. dollar exchange rates.

Bring that all together—earnings, inflation, rates—and you start to build a sense of the billion-dollar question: Where are we in the business cycle? You also uncover some potentially attractive investment opportunities.

The Late Phase of the Business Cycle at Work

We believe we are entering the late phase of an unusually long business cycle. Historically, that has meant rising inflation and higher commodity prices. Broad commodity benchmarks are up strongly so far in April and well ahead of global equity markets so far this year. Recent strength from energy, precious metals and industrial metals have paced these markets.

An important (although potentially more obscure) aspect of commodities markets is that, after many years in “contango” (where later-dated futures trade more expensively than near-dated ones), the majority of commodity futures curves have moved toward “backwardation” (where the later-dated contracts are cheaper).

That makes commodity futures more attractive for investors because they start to earn what is called “roll yield.” More fundamentally, the rising dynamic at the front of the curve reflects that demand is beginning to put a strain on supply, or at least that hedgers, producers and investors are moving back toward a more “normalized” relationship after years of weak demand.

This is the late phase of the business cycle at work.

Opportunities in the Pipeline

Higher commodity prices likely mean growing earnings for commodity companies. Let us focus on the energy sector, in particular.

WTI crude oil is up nearly 40% over the past 12 months and close to breaking $70 per barrel for the first time in more than three years. In the Q1 U.S. earnings season, analysts anticipate substantial earnings growth from energy companies over the same period last year, and the estimate for the sector’s earnings growth in 2018 is among the highest in the S&P 500 Index. Yet valuations, while they have recovered considerably over recent weeks, still appear dislocated from the underlying strength in energy commodities.

Furthermore, the sector is in acute need of capital. Supply can only meet rising demand if the infrastructure is in place to move it to customers. Evidence is mounting that the sector has a lack of pipelines and related assets to accommodate the recent rapid growth in production and rising consumption, however. Many pipeline providers structured as Master Limited Partnerships (MLPs) have struggled to fund that infrastructure because they have been out of favor with investors, elevating their cost of equity.

We think that makes pipeline providers especially interesting. MLPs offer attractive yields, particularly after regulators indicated in March that certain tax treatment may be changed, a ruling that created confusion in an already depressed sector but which we believe is unlikely to cause lasting structural damage. Regardless of legal structure, pipeline providers in general are toll-takers, which makes them less exposed to the full volatility of the underlying commodity price—yet many have a meaningful proportion of their revenue with automatic escalators linked to inflation. The sector also has an important role to play in transporting U.S. shale gas, and therefore in the transition toward less carbon-intensive power production.

Benign Feedback Loop

Energy may be an emerging opportunity, then. In addition, the dynamics of the sector hold important lessons about the late phase of the business cycle as a whole.

There are many areas of the economy where investment has been subdued, leaving a shortfall of capital to meet rising demand from business and consumers. For a time, increasing investment can improve productivity and increase the economy’s capacity to respond to higher prices—moderating inflation and extending the business cycle in a benign feedback loop. Releasing such pent-up energy can result in strong momentum as the cycle matures.

That momentum will be described by signals coming from earnings, inflation and rates. It is encouraging to see investors’ attention rightly turning back to those signals.