Vijay Chandar: Hello, and welcome to another edition of Wealth Management Insights. I’m Vijay Chandar, Head of Thematic Investing for Morgan Stanley Wealth Management. I’m recording this on Wednesday, March 23rd, in Manhattan, New York.
In recent weeks, oil prices around the world have spiked to multi-decade highs. The latest surge can be attributed to geopolitical concerns, but we should remember that both crude oil and natural gas were rallying before Russia’s invasion of Ukraine, given improving demand and slower supply growth. That, of course, followed a dramatic blow at the start of the pandemic, which took oil prices into negative territory for the first time in history.
When we, as thematic investors, consider this kind of oil-price volatility, it’s important to ask about the long-term implications. Our view is that the current environment presents an attractive thematic investment case. Consider the past decade or so has been a rather challenging environment for the energy investor. Even with the rally from last year on, the S&P 500 energy sector is down more than 20% from its 2014 all-time high and has underperformed the index itself by almost 300% since the beginning of 2010. This period of pain, however, has driven a rethinking across the industry. Companies are now focused on reducing investment and prioritizing returns and cash flows. This, coupled with more-appealing valuations, could set up a compelling starting point.
Now, another question we should be considering is how the industry and related policies might change, and what this means for investors. On this front, we see two specific opportunities: the US midstream industry overall and companies exposed to liquified natural gas, or LNG. We’ll go through each briefly.
Midstream exposure is generally tied to transporting, storing and processing raw commodities, and, for the most part, the industry is more reliant on volumes rather than commodity prices themselves. Underscoring this point, profitability for the industry has held up relatively well despite big price volatility in recent years. Also, over the past decade, the industry has shifted to focus on cash-flow generation and a more-sustainable funding model. These improvements, however, have not been rewarded by the market. The industry, for instance, trades at a historic discount to its closest S&P 500 sector peer, utilities.
Also affecting valuation has been concern about volume growth, as decarbonization trends and regulatory pressures may dim the long-term outlook for oil and gas infrastructure. This is a valid concern, but, in our view, this is also where the current geopolitical environment could potentially be an underappreciated catalyst. Recent world events have led to renewed and heightened concerns about energy security. And if, over the intermediate term, the US continues to emphasize energy security and focus on oil and gas production alongside renewables, volume trends for midstream should remain strong. Policy also could incentivize domestic production growth, or, at a minimum, shift away from constraining it, which may help support valuations.
Now, within midstream, we see LNG export as another compelling investment theme. LNG has been considered a “transition fuel” given that it generates just about half of the harmful emissions of coal. Even before recent geopolitical strains, rising energy prices were shining a light on the role that LNG could play in the energy transition. Currently, Morgan Stanley & Co. Research expects demand will increase by 50% over the next eight years. Given lack of investment, new projects may be needed to meet that demand growth by the end of the decade. With these favorable supply-and-demand dynamics, we expect valuations for LNG-exposed names to hold up.
So, these are some of our latest thoughts on potential thematic opportunities alongside improving sentiment for US oil and gas production and US export opportunities amid greater energy security concerns. If you are curious how these ideas might fit into your portfolio, or if you’d like a copy of a more-detailed report with specific investment recommendations, please reach out to your Morgan Stanley Financial Advisor. Thank you all for listening.
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