ECONOMIC COMMENTARY

CIO Update: what’s happening with energy stocks?

In this week’s CIO Update, Shannon Saccocia takes a deeper look at the energy sector. From the infrastructure boom to changes over the last few decades and threats to current favorable pricing. Listen now.


Audio transcription

Shannon: Hello, and welcome to Boston Private Perspectives. I'm Shannon Saccocia, chief investment officer at Boston Private. As always, I wanna thank you for joining me today. As we move towards the end of the quarter, it is incredible to think about where we were just a year ago and how much has changed in the economy and the markets since then.

One of the themes that we've continued to discuss is the reflationary rebound that gained steam over the last several months. We've talked about stimulus and accommodative monetary policy and how they've helped to drive that rebound, as well as the valuation gap between growth and value that has helped push investors into the more cyclical sectors of the market. Today, I'd like to drill in, no pun intended, on a particular part of the market, and that's the energy sector.

One of the things that we're hearing often from clients over the past month or so is, you know, what is happening with the energy sector. Energy stocks if you look at them using a common ETF called the XLE, which is the SPDR energy sector ETF are up almost 28% for the year. Whereas the S&P 500 is only up a little over 4.5%. So there's been a significant out-performance of energy stocks over the course of the last several months. And for good reason given the reflationary rebound that we've been talking about over the last few weeks.

Another component of this is that investors are looking ahead to a potential boom and infrastructure spending that could help to drive energy prices even higher. So, I wanna take a step back and talk about what we've seen historically as it relates to infrastructure spend. I also wanna discuss some changes in the energy market that have occurred over the last decade, how that plays into our expectations for energy prices over the next several years, and relevant threats to the thesis that has been playing out over the past few months that the energy sector will continue to benefit from higher energy prices.

Let's start with that historical experience. The last time that we experienced a significant boom in commodity prices was concurrent with a significant increase in infrastructure spend out of China. If we go back to the financial crisis, one of the things that precipitated the financial crisis was a massive unwinding, not only of the housing market here in the United States, but of the global commodity boom that we had been experiencing for the 10 years prior to 2007. Oil prices at the time were continuing to climb and the threat of $200 per barrel oil price for WTI crude was very much a reasonable expectation given the pace of appreciation that we'd seen in energy prices up through that point.

The challenge was is that much of this infrastructure, or excuse me, the challenge of energy prices moving higher was coincident with the Chinese government's massive amount of infrastructure spend that they had put into their economy ahead of the financial crisis. And so, that not only had increased the demand for energy as well as the other commodities like industrial metals and precious metals, but it created a feeling that there was going to continue to be limited supply to meet ever-growing demand over the course of the next 20 or 30 years. And this infrastructure boom is what investors in the United States are looking at potentially occurring here in the back half of the year and through 2022 and likely into 2023. So, that has helped to push commodity prices, in general, and energy prices, in particular, higher over the last several months. And that is consistent with other fits and stats of infrastructure spending that we've seen over the course of the last 50 or 60.

The challenge to that is that we've seen since the bursting of the commodity supercycle clear changes in the energy market. Number one prior to, you know, the late 90s and early 2000s, the global oil market was essentially controlled by OPEC. And the supply that was coming onto the market was primarily regulated by this group. There were certain price targets that OPEC members were looking to hit over the course of time and the demand fluctuated much more significantly than supply did prior to the energy renaissance here in the United States.

And so, to counteract kind of increases in demand, OPEC members would determine when it made sense to release additional supply into the market. But frankly, given the fact that many oil producers, particularly large oil producers like Russia and Saudi Arabia rely on the revenue from oil sales in order to fund their government and essentially social programs in their countries, it is difficult at times for them to feel incentivized to increase supply and add additional supply into the marketplace, even when demand has picked up to a point where we see massive increases in oil prices.

So, what's changed is that OPEC has now become OPEC Plus. There are more countries that have a seat at the table for OPAC and therefore, for instance, Saudi Arabia's control has been diminished over time. There've also been more producers that sit outside of the OPEC Plus construct, namely the United States that have seen supply come online over the course of the last 10 years or so, and have upset that dynamic or disrupted that dynamic that was created by essentially the collusion amongst these OPEC countries historically to keep oil prices at a certain level.

And that leads into our expectations for energy prices over the next several years. Coming into 2019, or excuse me, 2020, the expectation was that there was going to continue to be excess supply versus demand. And then we had the pandemic and there was clearly excess supplies that related to demand based on the sharp decline in economic activity that was experienced globally.

Coming into 2021, there certainly have been expectations of higher levels of demand in the commodity space. We've seen market increases not only in energy prices but, you know, more pronounced increases in areas like lumber and copper. And we're seeing that slow a bit as of late, not as much on the lumber side, but in as it relates to copper. And that's a result of, I think, a reset of expectations on how big a boom we'll actually see as it relates to commodity prices. And so, if we look at the next several years, we will experience some upward pressure on energy prices as that mismatch between supply and demand persists.

A lot of supply went offline last year as a result of the lower demand. That supply has to come back online. OPEC Plus has agreed to limit supply into the market amongst its members. But at some point, there will be a tipping point where that additional supply is likely to come back on. And in the interim, we are seeing a lot of the areas of economic reopening as it relates to, you know, additional shipping in the form of truck cargo. We're seeing a potential pickup in flights. So, obviously, the demand for jet fuel, we would anticipate increasing over the course of the next several quarters. But a lot of that has been pulled forward already into oil prices as well as into energy stock prices. And so, a low or plateau over the course of the next couple of quarters, as it relates to energy prices is more than likely.

And so, our view still going into 2022 and 2023 is that there is likely to continue to be ample supply in the marketplace. We probably don't get certainly back to the energy prices that we were experiencing in 2020, but upward pressure, you know, into, you know, above $70, $75 a barrel for WTI crude seems unlikely. As that, you know, sort of the prices where we are today, it makes sense for many producers to take advantage of those prices and put more supply into the market, particularly as they're grappling with a still somewhat tenuous economic situation in their countries.

And so, we also anticipate that here in the United States, we'll start to see some more supply come back online as well. This demand thesis is really the biggest question for us because it comes back to if we believed that the market was likely oversupplied through 2022 and maybe into 2023 already, even if some of that supply has come offline, it's likely to come back online in the back half of this year and the demand, the forces of demand for energy prices, in particular, have changed over the course of the last decade.

And there are threats to this demand thesis playing out. Number one, just, you know, generally, technological innovation. The fact that we are able to extract oil and natural gas, you know, in a more scalable, more efficient way allows for other producers, other suppliers to be able to extract fuel from the ground and sell it even at lower prices. So, what could have been seen as prohibitively expensive eight or nine years ago costs have come so far down due to technological advancement that it makes sense for some of these suppliers, even if we don't get to higher levels of crude oil prices, in particular, to be putting that supply into the market at these levels.

There's also the thesis that, you know, we've become more efficient in our usage of fossil fuels over the last decade and certainly in the 15 years since the bursting of the commodities bubble in 2006, in 2007. And so, with that additional efficiency, even if we see an increase in demand from activity, the demand will not be the same as it was previously during previous infrastructure booms because we become more efficient. And you see this in terms of, you know, not just in really clear examples like electric vehicles and the increased use of wind, you see it in kind of everyday usage of fossil fuels as well. Just given, you know, the standards that have been put in place for, you know, kind of traditional passenger cars and trucks over the course of the last 15 years.

And so, with those threats and those very real threats ahead of us, it's hard to see an environment over the next, say, 5 to 10 years where energy prices will continue to increase to a point where energy becomes a much more meaningful part of an investor's basket. That's not to say that energy shouldn't be a part of your investment portfolio. What's important to remember is that some of the same trends that made energy stocks, in particular, less attractive prior to the pandemic are likely to continue to weigh on the prospects for energy stocks in the next 5, 10, 15 years as well.

And so, being selective thinking about what the relative opportunity is for those companies in an environment where they are likely to get a reflationary rebound led bump which we certainly have seen thus far this year. But acknowledging that at some point, you know, that demand thesis will need to play out in order to justify oil moving higher than it is at its current levels and therefore justify the potential for outsized revenues and earnings, particularly for energy producers. And that's the piece that we are a bit more skeptical on just given the dynamics of what we've seen, and even in the event of a large-scale infrastructure package, you know, given the fact that it is going to be led by the Democrats, it seems unlikely that we will be in a position where it's very fossil fuel-heavy in terms of implementation.

And that's why we look at the opportunities presented from the infrastructure package later this year in a more nuanced way, and certainly not in the same way that we saw infrastructure build implemented by the Chinese government, for instance, back in the early 2000s. And so, it's important to compare and contrast what a current day infrastructure package is going to look like and be very thoughtful about the sectors and industries that will benefit most from that.

Energy is clearly going to continue to benefit from a rotation from growth to value, from deflation to reflation, from, you know, just an overall view that the economy is likely to accelerate globally, perhaps even faster than we had anticipated a few months ago. But the caveat here is just from a long-term perspective. There are probably more attractive ways, you know, out a year, 2 years, 5 years, 10 years to take advantage of some of the longer-term positive impacts that would come from such a move and such a meaningful improvement in the global economy.

Thanks again for listening to this week's podcast. I want to encourage all of you to reach out to our team here at Boston Private with any questions or concerns you may have. If you have any questions or thoughts on my points today, you can find me on Twitter at Shannon Saccocia. You can also read our latest perspectives on the markets, the economy, taxes, and estate planning by visiting bostonprivate.com.

And if you want all of this information delivered right to your inbox, I encourage you to sign up for our newsletters while you're there. Be sure to subscribe to the ''Boston Private Perspectives'' on Apple Podcasts or Spotify or wherever you prefer to listen. And I look forward to coming to you again next week.

Shannon Saccocia, CFA, CIMA®

Shannon Saccocia serves as Chief Investment Officer at SVB Private, and is responsible for setting the overall investment strategy for the firm. She oversees the asset allocation, research, portfolio management, external manager search and selection, portfolio implementation, trading, and investment risk management functions.

The views expressed in the article are those of the author and/or person interviewed and do not necessarily reflect the views of SVB Private or other members of Silicon Valley Bank and SVB Financial Group. The materials on this website are for informational purposes only, are subject to change and do not take into account your particular investment objective, financial situation or need. Since each client’s situation is unique, you should consult your financial advisor and/or tax planning professional before acting on any information provided herein