John Manley

The energy sector: Bridge to tomorrow?

AdvantageVoice® Blog—2-11-13
John Manley, CFA, Chief Equity Strategist

“…life is 95 percent anticipation.” Gloria Swanson

I have a problem that I would like to share with you. I believe that the economic outlook across the globe has improved a bit over the last several months, and I suspect that that trend may continue. While I would like to anticipate this by increasing exposure to more economically sensitive areas, I know that these things seldom move in a straight line. To put it another way, I would like to emphasize cyclically exposed commodity groups sometime this year and next, but I am not sure that we have reached the proper entry point.

China appears to be lifting out of its torpor, and Europe is no longer in freefall. Stability in the U.S. housing market seems to be buoying American consumers even in the face of higher taxes. Central banks around the world appear to be intent on nurturing and encouraging these trends. These central bankers have likely decided that, if they make a mistake, it should be to keep interest rates too low for too long rather than raising them (or allowing them to rise) too much, too soon. At some point this should translate into a belief that commodity prices can resume an upward trend and hold it for a while. In the past, this perception of the continuity of appreciation has been a boon for commodity stocks. The overt or covert desire of many nations to depreciate their currencies should not hurt the story either.

It is a question of timing. The improving economic trends I alluded to are in their very early stages and subject to a number of stumbling blocks in the first half of this year. Tax hikes, budget cuts, vacillating consumer sentiment, and currency fluctuations are but a few of the issues that could delay or disrupt this process. I suppose that I want to have it both ways. I would like to get exposure to something cyclical for what I see as the long run, but I also want to have something with size, quality, and yield to hedge these issues in the short run. Actually, I think that there is something that could resolve this dilemma.

I would overweight the energy sector. Obviously, oil and gas are commodities that tend to rise or fall with perceptions of economic growth. Yet oil and gas are somewhat unique among commodities because they cannot be recycled. Once burned, they must be replaced by new supply.

In addition, the simple forces of supply and demand in the oil market are and have been tempered by powerful entities with vested interests in keeping prices high or low. The Texas Railroad Commission, the Seven Sisters, and now OPEC have sought to moderate unwanted price fluctuations over the years. Finally, a number of the integrated oil and oil service companies are large, high-quality entities that pay a meaningful dividend and are somewhat insulated from commodity price fluctuations. Higher oil and gas prices can help them in the long run, but they are insulated from downward price fluctuations in the near term.

Gas is somewhat different. It can be easily burned but it is difficult to store and transport. In my opinion, the recent increase in recoverable domestic gas reserves will require massive infrastructure spending to bring it to market. The companies that do this work could produce surprisingly good earnings for an extended period of time. They may not be as big or as dividend rich as the large integrateds, but they should see a rising demand for their services over a substantial period of time. I think this may make them more volume and growth stories than simple pricing power plays.

In summary, I think that the energy sector still offers decent valuation and good fundamentals. It also gives an early exposure to an area, commodities, that we suspect we will want to own more of in the future.

The views expressed are as of 2-11-13 and are those of Chief Equity Strategist John Manley, CFA, and Wells Fargo Funds Management, LLC. The information and statistics in this report have been obtained from sources we believe to be reliable but are not guaranteed by us to be accurate or complete. Any and all earnings, projections, and estimates assume certain conditions and industry developments, which are subject to change. The opinions stated are those of the author and are not intended to be used as investment advice. The views and any forward-looking statements are subject to change at any time in response to changing circumstances in the market and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally, or any mutual fund. Wells Fargo Funds Management, LLC, disclaims any obligation to publicly update or revise any views expressed or forward-looking statements.


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