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Play Offense in Energy

With oil prices higher—and likely to rise more—energy stocks may outperform this year.

By: Lisa Shalett, Wealth Management Head of Investment and Portfolio Strategies

At long last, oil prices have broken out of the $40-to-$55 a barrel range of the last two years. Now U.S. crude oil is trading above $60 and I think it could stay in a range of $60-to-$70 a barrel in 2018. 

This is positive for oil stocks as well as energy infrastructure plays, which have lagged the broader market. Investors have avoided energy names due to concerns about oversupply—both near term, as U.S. shale producers ramped up and inventories soared, and long term, due to the popularity of electric vehicles and alternative clean energy sources.

I believe the recent move up in oil prices is sustainable for quite a few reasons. Below are seven:

  • Supply is falling. Global inventories are coming down as the oil market is currently undersupplied by a half million barrels a day.
  • Demand is rising. Global growth estimates, a key input for oil demand, are rising. Plus, severe weather in the U.S. has led to a surge in domestic demand.
  • OPEC supply cuts have held. The oil cartel ordered members to reduce supply in hopes of bolstering prices in 2016. Compliance with that plan has been higher than expected.
  • The crisis in Venezuela is worsening. It has already caused a drop in oil production there. 
  • U.S. shale producers are holding back on expansion plans. They are focusing more on profitability and cash flow than rapid growth.
  • The U.S. dollar is weak. That typically means commodities priced in dollars, like oil, may rise in price.
  • The oil futures market is signaling a price gain. Current spot prices are higher than futures prices, a state known as “backwardation,” which indicates that speculators and physical producers are willing to pay a premium for immediate delivery as inventories fall. Morgan Stanley & Co. research shows that energy stocks have tended to outperform the S&P 500 when the oil futures are in backwardation. 

Bottom Line: Rising oil prices are positive for energy stocks, which have lagged the broader market. Energy firms are already reporting better earnings and seem very cheap based on their historic book value compared to the S&P 500. 

I advise investors to consider using actively managed strategies to get exposure to the energy sector. Energy infrastructure master limited partnerships (MLPs) may be a good option for investors seeking potential income, exposure to real assets and potential tax benefits.

Risk Considerations

MLPs

Master Limited Partnerships (MLPs) are limited partnerships or limited liability companies that are taxed as partnerships and whose interests (limited partnership units or limited liability company units) are traded on securities exchanges like shares of common stock. Currently, most MLPs operate in the energy, natural resources or real estate sectors. Investments in MLP interests are subject to the risks generally applicable to companies in the energy and natural resources sectors, including commodity pricing risk, supply and demand risk, depletion risk and exploration risk.

Individual MLPs are publicly traded partnerships that have unique risks related to their structure.  These include, but are not limited to, their reliance on the capital markets to fund growth, adverse ruling on the current tax treatment of distributions (typically mostly tax deferred), and commodity volume risk. 

The potential tax benefits from investing in MLPs depend on their being treated as partnerships for federal income tax purposes and, if the MLP is deemed to be a corporation, then its income would be subject to federal taxation at the entity level, reducing the amount of cash available for distribution to the fund which could result in a reduction of the fund’s value.

MLPs carry interest rate risk and may underperform in a rising interest rate environment. MLP funds accrue deferred income taxes for future tax liabilities associated with the portion of MLP distributions considered to be a tax-deferred return of capital and for any net operating gains as well as capital appreciation of its investments; this deferred tax liability is reflected in the daily NAV; and, as a result, the MLP fund’s after-tax performance could differ significantly from the underlying assets even if the pre-tax performance is closely tracked.

Investing in commodities entails significant risks. Commodity prices may be affected by a variety of factors at any time, including but not limited to, (i) changes in supply and demand relationships, (ii) governmental programs and policies, (iii) national and international political and economic events, war and terrorist events, (iv) changes in interest and exchange rates, (v) trading activities in commodities and related contracts, (vi) pestilence, technological change and weather, and (vii) the price volatility of a commodity. In addition, the commodities markets are subject to temporary distortions or other disruptions due to various factors, including lack of liquidity, participation of speculators and government intervention.

Equity securities may fluctuate in response to news on companies, industries, market conditions and general economic environment.

Asset allocation and diversification do not assure a profit or protect against loss in declining financial markets.

The indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not represent the performance of any specific investment.

The indices selected by Morgan Stanley Wealth Management to measure performance are representative of broad asset classes.  Morgan Stanley Smith Barney LLC retains the right to change representative indices at any time.

Because of their narrow focus, sector investments tend to be more volatile than investments that diversify across many sectors and companies.

Investing in currency involves additional special risks such as credit, interest rate fluctuations, derivative investment risk, and domestic and foreign inflation rates, which can be volatile and may be less liquid than other securities and more sensitive to the effect of varied economic conditions. In addition, international investing entails greater risk, as well as greater potential rewards compared to U.S. investing. These risks include political and economic uncertainties of foreign countries as well as the risk of currency fluctuations. These risks are magnified in countries with emerging markets, since these countries may have relatively unstable governments and less established markets and economies. 

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