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Play Offense in Energy

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

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.

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MORGAN STANLEY ACCESS INVESTING