The energy sector has seen a great deal of volatility over the past several years, although stocks within this group have made a strong recovery off the COVID bear market bottom. Where is the energy market, both fossil fuels and renewables, headed from here? Paul Baiocchi, the senior investment strategy advisor at SS&C ALPS Advisors, enters the ETF Think Tank to discuss MLPs, the migration towards renewable energy, ESG investing in the energy sector, and more.
With much discussion centering around inflation at the moment, how can energy and commodities be expected to perform in such an environment. Baiocchi says that midstreams, which focus on the transport, storage and processing on various energy products, have traditionally performed well in inflationary cycles. As inflation rates rise and oil prices go up, all points on the stream tend to benefit, but midstream companies, which tend to have relatively steady demand regardless of energy price levels, can have some defensive properties to them as well. Because commodities can be priced with an inflation rate built in, they have some similarities to TIPS. Value stocks also tend to do well in inflationary environments.
Most people are aware that MLPs have struggled mightily recently along with the rest of the energy sector. Baiocchi says that the previous environment, where many MLPs focused on high leverage and distribution growth, fueled some of the sector's issues and allowed some structures to focus on short-term benefits over long-term potential. He notes that conditions have begun improving as companies focus more on financial flexibility than high yield. Leverage is coming down and distribution coverage is improving. There is also a heightened focus on buybacks and paying back debt that’s creating a backdrop of greater discipline and higher free cash flows. These factors should help lower the sector’s overall risk and enhance opportunities going forward.
How can (or should) investors consider implementing MLPs into a market that’s long rewarded growth stocks? Baiocchi explains midstreams fit within the objectives of retail investors and could address the underweight to energy that exists in many portfolios. In the Russell 1000 index, energy accounts for less than 3%. In growth indices, there may be little to no exposure at all. Even if you’re running a very basic index approach, it’s become growth-overweight. Value sectors, such as midstreams, help to offset that. Even when midstreams should have had the worst possible year in 2020 as there were great concerns about energy prices, bankruptcies and counterparty risks, they still delivered results that were in line with what was expected at the beginning of the year. Baiocchi views that as a sign of the group’s defensive orientation. This type of behavior could benefit investors in the long run.
An interesting topic that was brought up was the evolution of energy companies in the ESG space. Many would dismiss energy companies from ESG indices based on the traditional view of what they do, but many are transitioning into renewable energy products. Baiocchi believes that there is some nuance to this. He feels the reality is that decarbonization means more electricity demand and while wind and solar will play a large role, they tend to be high latency energy sources. Many companies, however, are developing renewable strategies and pipelines can be restructured to help move renewable energies, so midstreams will also play a huge future role.
Given the focus on renewables, will we see oil companies begin to show up in some of these ESG indices in the near future? Baiocchi feels that when taking a broader view, it’s probably less likely that it will happen soon. One of the issues with larger ESG indices is that they aren’t often designed to be as personal as they should be. Definitions of what qualifies as ESG are often different. One index may exclude weapons producers, while another may allow them. MLPs have a better chance of showing up sooner in customized ESG indices, but the large ones will probably exclude the fossil fuel space for a while. Direct indexing is the likelier source than a traditional index ETF.
The one challenge Baiocchi sees in the MLP space currently is where is future growth going to come from? Capex budgets are coming down now, which is good for free cash flows, but it’s less money spent on future growth. The U.S. government may prevent the development of new pipelines and it may become harder to move hydrocarbons around. The biggest opportunity may lie in ESG and renewables, but the return on investment with these projects is still unclear.
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