By Greg Sharenow, Portfolio Manager, Commodities and Real Assets, and John Devir, Portfolio Manager and Head of Americas Credit Research, at PIMCO
The Organization of the Petroleum Exporting Countries and its allies on 5 October announced plans to reduce oil-production quotas by 2 million barrels a day (b/d) starting in November. The realized output cut is expected to be closer to 1 million b/d, given most member nations are already producing below quota levels.
We view this move as supportive for energy prices, as commercial inventories are currently below average and would have been at historic lows if not for global strategic petroleum reserve releases. This action stands also to exacerbate global inflation, complicating the efforts of central bankers.
For investors aiming to hedge these inflation concerns or capitalize on a potential rebound in energy prices, commodity indices offer a compelling opportunity, particularly given the historically high positive carry (forward prices are lower than spot) in the main commodity indices. Further, the North American energy patch stands to be a primary beneficiary of the OPEC+ plan.
OPEC+ reasons are many and signal is clear
OPEC+ argued that the move was preemptive to avert price weakness in case the Federal Reserve’s policy tightening to rein in inflation leads to a demand slowdown. Another reason offered was that the world is underinvesting in upstream oil and gas, so supporting prices in the face of economic weakness will serve the long-term economic interests of everyone. With global upstream investment on a real basis roughly 25% below 2018-2019 levels, there certainly is merit to supporting higher investments.
While not directly stated, we wouldn’t be surprised if rebuilding spare capacity in key OPEC states – which is near historic lows – to provide a buffer for future supply outages was also a factor in the decision. In addition, it is hard not to wonder if the proposed price cap on Russian oil by the Group of Seven (G-7) nations was an unsettling precedent for other key oil producers, which have elected solidarity with Russia at the potential ire of global consumers.
Commodity investors stand to gain
While the oil market has rallied on the OPEC+ announcement, this retracement is rather mild relative to the sell-off seen in recent months on global growth concerns. As we look ahead, we believe the market could well be underappreciating the potential decline in Russian output as European Union sanctions escalate.
Demand remains a concern with the tightening of financial conditions, but the remarkable fact of the past year is that the energy and broader commodity markets have tightened so much without China acting as a growth engine. Should China aim to stimulate its economy to offset external headwinds, the impact on commodity markets would likely offset negative demand implications from rising interest rates. With global petroleum inventories near the bottom of the historical range, leading to extremely high positive carry in the markets, we view the OPEC+ actions as supporting a positive return outlook.
North American energy patch stands to benefit
One clear beneficiary of this backdrop is the North American energy complex. We view master limited partnerships (MLPs) and the midstream energy sector as primary beneficiaries, given constrained supply globally requires continued growth in output in North America, with companies leveraged to crude oil and liquefied natural gas (LNG) as our favored expressions.
The OPEC+ announcement will likely provide U.S. producers with greater confidence to increase capital spending investments over the next several years, which is a clear positive for midstream energy. We project low-to-mid-single digit growth in earnings before interest, taxes, depreciation, and amortization (EBITDA) for MLPs and midstream energy over the next 3-5 years.
Combined with a current yield of about 7.6% on the Alerian MLP Index, we believe MLPs offer an attractive total return potential of low double digits and an opportunity to benefit from a global energy-constrained environment. Although a demand shock would be negative for returns in the near term, energy sector balance sheets are better positioned to withstand an economic slowdown than in previous cycles.
Risk to portfolios from inflation offsets our concerns about economic slowdown
While we believe there is significant value to be found in the energy markets for generating returns as well as hedging inflation risk, in a scenario where higher interest rates lead to an economic recession (i.e., a hawkish mistake by the Fed) we would expect energy equities and energy prices to struggle. That said, we view the energy sector as a compelling investment opportunity given inflation risks in broad portfolios as seen over the past year. In addition, forward prices remain below levels we believe will motivate additional, much needed capital to move off the sidelines.
As OPEC Secretary General Haitham Al Ghais said, “energy security has its price.” In our view, the price is likely higher than the market currently suggests.