Adding energy to your investments

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The cyclical sectors, which include consumer cyclicals, basic materials, financial services and energy, have a considerable correlation with different phases of the business cycle. The defensive sectors, such as consumer staples, communication services, healthcare and utilities, do not. What scares many investors away from the cyclical space is the fear of performance blowouts when the cycle turns, particularly when invested with a ‘buy and hold’ mentality. Cyclical stocks should never be bought on this basis. Instead, you need to identify an active sector strategy that manages the cycle.

The energy sector certainly has one clear driver – the price of oil. It also has a range of sub-sectors that react to the price in very different ways. This ranges from high sensitivity typically found in the ‘upstream’ sub-sectors closest to the source of oil production, including seismic, drilling, service, exploration and production, to relatively low sensitivity ‘downstream’ sub-sectors such as shipping, pipeline, refining and major oil companies.

Taking exposure to a cyclical sector like energy through a passively managed ETF that follows the benchmark is not a suitable option. A portfolio that tracks the benchmark exposes investors to the highest weightings of highly oil price sensitive areas at the top of the cycle, while reducing it at the sector’s lows. Exposure to these upstream sub-sectors hit almost 40 per cent during oil price peaks of 2011 and 2014, while the same sub-sectors fell to 29 per cent during the energy sector’s lows in 2016. If investors adopted a passive ETF-based approach, they would have been holding low oil price sensitivity at the low points of the cycle and much higher oil price sensitivities at the highs. This is the complete opposite of what is desirable.

Highly cyclical sectors should be managed in a very different way to the management of low cyclical sectors. For this reason, investment managers should place the six to 12-month directional forecast of the oil price at the very core of their methodology. By using sub-sectors as tools, managers can then either desensitise a portfolio when they believe the oil price is heading lower or increase sensitivity when the oil price is heading higher. The inclusion of such a strategy within an investor’s portfolio allows them to benefit from an actively managed cyclical sector supported by a dedicated and experienced manager.

The energy market is currently entering a very interesting and exciting period. After years of shrinking cash flow and the resulting decimation of capital expenditure on long-cycle oil supply projects, which take four to eight years to start production, the market has cleared its excess oil inventories. The energy market is now entering a period when activity has to be extremely strong to balance what is increasingly looking like an undersupplied market. We are approaching the time when the market desperately needs oil with a short lead time.

Short-cycle oil, currently being produced from on-shore US basins with a lead time of approximately six to eight months can indeed fit that bill. Thanks to some incredibly strong productivity gains over the last five years, short-cycle oil has moved from being one of the most expensive to one of the cheapest sources of oil outside of OPEC. Production is contracting in order to balance the market, particularly in the offshore space such as the North Sea projects. The US, however, stands to garner much of the market share growth that will be on offer over the next five years. Investors should be looking to the areas that are growing, such as the Permian Basin, which has the capacity to increase supply by 10-25 per cent annually over the foreseeable future without creating oversupply.

But even with strong US activity, time looks to be against the industry and the market is looking undersupplied as we enter the close of the decade. Consequently, an investor looking to benefit from the value that can be found in the energy sector, should look for a portfolio that is holding high oil price sensitivity to maximise their returns during the strong part of the cycle.