Year to date the energy sector has produced positive returns and for the most part has remained anchored to the S&P500 benchmark. Given the geopolitical backdrop, the sector has seemed possibly overly stable.
With one of the biggest oil producers, Russia, at war and somewhat isolated for over two years and the recent conflict between Israel and Hamas, one would have expected a much more significant risk premium built into the price of oil. What is probably calming the markets, is the fact that Russia continues to pump and was able to divert much of his production toward Asia while the Middle East conflict has not yet spread into a larger conflagration.
Looking ahead, we are entering into the summer driving season, which usually ushers in higher prices. After the recent events, we are also facing possible instability in Iran, which could push oil prices toward $90 a barrel. The United States seems to have limited ability to increase production and it may not be able to be a mitigating force, should prices spike in the next few months.
From the perspective of equity valuations, despite positive performance over the last few years, energy companies are, in general, still trading at attractive multiples. To some extent, this may be due to a general dislike from investors for a sector that shows significant cyclicality and is stained by the “bad boy” characterization in the climate change narrative. With so many institutional investors divesting from fossil fuel related companies, we may never see valuations as high as in the past. However, these are profitable businesses, and generally cash flow producing machines.
For years, we have liked energy infrastructure companies because of their ability to generate very high and very visible distributable cash flows which turn into significant payouts to investors. In a few remaining instances, some companies, still structured like Master Limited Partnerships, also offer a tax advantage for part of their distributions. A new twist on this energy niche is an emerging correlation to AI. As Artificial Intelligence requires increasing amounts of power, electricity providers face rising demand for their product. In turn this translates into more volume for natural gas pipeline operators. Additionally, rising headwinds in building new infrastructures make the existing network of pipelines and storage increasingly attractive.