2/16/2021: Market Update by Jack Ablin, Chief Investment Officer at Cresset
Frigid temperatures are gripping the nation, fueling rallies in the energy complex. Brent crude rose 1.4 per cent to $63.30/bbl, a pre-pandemic level. Natural gas, a main source of home heating, jumped more than 4 per cent. US natural gas demand was expected to hit a single-day high on Monday, according to The Wall Street Journal, as thermostats were turned up in parts of the country that rarely use heat.
Extreme weather this week underscores Cresset’s belief that energy infrastructure deserves an allocation. Critics argue that the Biden administration’s desire to promote clean energy at the expense of fossil fuels is a big-picture impediment that will quash the complex. We’re big believers in alternative energy also. Yet energy infrastructure is cheap by virtually any measure and near-term valuations are compelling enough to play the little picture. Current prices trade at slightly more than 10x trailing earnings, their cheapest level since the bottom of the financial crisis. Today’s price-to-cashflow ratio paints a similar picture. While growth-oriented sectors, like technology and communications, are trading near their highest levels over the past 20 years, energy shares are trading near rock bottom.
Energy infrastructure also offers generous yield in an otherwise impecunious income environment. The sector carries a 6.5 per cent dividend yield, substantially higher than even high-yield bonds. History has shown that energy’s dividends account for more than three-quarters of the sector’s total return. Admittedly, the sector’s price performance has in essence flatlined for the last five years. The Alerian Energy Infrastructure Index lost more than 30 per cent of its value last year. Year to date, however, the index has bounced 12 per cent.
Master limited partnerships, comprising half of the sector, tend to ebb and flow with crude prices. The sector plunged last April when crude cascaded into negative territory and recovered on the back of higher oil prices. Yet MLPs have tended to trade in lockstep with crude. Unless investors believe pricier crude is temporary, master limited partnerships are trading about 20 per cent below where $60/bbl crude would suggest. Even a partial convergence would imply a double-digit price gain, according to Cresset’s analysis.
Investor attitude toward the sector is part of the reason why energy infrastructure hasn’t participated to the extent fundamentals would suggest. The 10 largest closed-end energy funds have historically traded at an average 6 per cent discount to their net asset values; that’s generally because of the imbedded management fees. Normalizing for the persistent discount allows us to gauge investor enthusiasm for the sector. The funds trade above the 6 per cent discount when investors are bullish and below 6 per cent when they’re bearish. Energy funds traded at as much as a 24 per cent discount to NAV, on average, at the height of pandemic selling in March. Today they’re trading at a 17 per cent discount, reflecting continued investor bearishness. Extreme investor sentiment is a useful contrary indicator, since bearish investors’ low expectations tend to be susceptible to positive surprises. This week’s weather could prompt investors to rethink energy infrastructure.
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