Morgan Stanley: US energy sector could see sustained rally

Dec. 14, 2020
Poor capital allocation, deflationary commodity prices, and weak returns have led to a 250% underperformance for the US energy sector over the past decade. However, the trend has begun to reverse, Morgan Stanley said in a research note.

Poor capital allocation, deflationary commodity prices, and weak returns have led to a 250% underperformance for the US energy sector over the past decade resulting in its fall to 2.5% of the S&P 500 from a peak of 13%, according to Morgan Stanley. However, over the past month, the trend has begun to reverse as overly discounted valuations, shifts in corporate strategy, positive vaccine news, and election clarity have started to attract investors back to the space, Morgan Stanley said in a research note.

While commodity price risks remain and could create near-term volatility, three themes could support a sustained rally across much of the energy sector, it said.

  • Strong cash flow. In 2021, for the first time in over a decade, energy will generate an FCF (free cash flow) yield above the broader market — even at flat commodity prices. This cash inflection is the result of consolidation, cost reductions, and growing capital discipline that emphasizes FCF overgrowth — a necessary shift to make the sector more “investable.”
  • Attractive valuations. Despite the recent rally, valuations screen cheap versus history. With the backdrop of an improving FCF and return profile, the energy sector still trades at a 45% EV/EBITDA discount to the rest of the market — much larger than the 30% average over the past decade. Relative multiples for E&P and Midstream sit near 10-year lows.
  • The return of inflation. Morgan Stanley’s macro strategists forecast strong, above consensus global economic growth coupled with accommodative Fed and inflationary pressures — historically a constructive backdrop for cyclicals, including energy. Using monthly data looking back 30 years, the correlation between US inflation and energy sector valuations is strongly positive, with an R squared of 0.77.

“Energy transition is a risk, but not enough to de-rail the recovery,” Morgan Stanley said. While oil demand has historically grown at a steady rate, COVID-19 has accelerated the trend towards decarbonization. Mounting energy transition concerns create uncertainty around the durability of the sector's cash flow and potential for structural de-rating over time. Despite this, Morgan Stanley sees a strong case for multiples to re-rate higher from currently discounted levels.

Even under aggressive assumptions for new technologies that reduce carbon, Martijn Rats, an oil strategist at Morgan Stanley, expects oil demand likely would not peak until early in the next decade. In the meantime, even as oil demand growth slows, it will continue to comprise a meaningful portion of the energy mix. Concurrently, disciplined spending provides cash to shareholders now — supported by double-digit FCF yields, in many instances — and de-emphasizes resource growth that depends on long-term oil demand.