By Noah Barrett
- With the goal of diversification, the sovereign wealth fund of oil-producer Norway is considering exiting its oil and gas equity holdings.
- Other buyers could step into the market given the energy sector’s improving fundamentals and attractive valuations.
- Rather than allocation decisions of large investors, we believe the long-term prospects of energy will be largely driven by underlying supply/demand.
Last week, investors took notice of the announcement that Norway's sovereign wealth fund - the world's largest - was considering eliminating its allocation to oil and gas stocks. While such a move is hardly irrelevant - the fund holds close to $35 billion in energy stocks, representing over 1% of the global tally - we believe that the value of oil and gas equities is ultimately driven by the supply and demand dynamics of the underlying industry along with companies' ability to successfully execute their business plans and deliver shareholder returns.
Several large funds have already lowered their allocation to energy, but to date, the target of such selling has largely been coal. Some of these moves were driven by environmental concerns. Pressure from cheap natural gas has also played a role in coal's fate. Rather than for environmental considerations, Norges Bank, the fund's administrator, has stated an exit from energy stocks would occur with the aim of diversification. The country already has elevated energy exposure, with the sector accounting for one-fifth of GDP. A sizable allocation to energy within its sovereign wealth fund could be seen as doubling down on the sector.
In our view, it is important to not confuse allocation decisions by large investors with the underlying fundamentals of the oil and gas industry. Just because Norway feels that it is prudent to manage its energy exposure, the world is not going to start using fewer hydrocarbons. In fact, we believe that diversification cuts both ways. Countries with little to no domestic energy industry may want to increase their wealth fund's allocation to the sector.
As energy tends to be a natural hedge against rising prices, net energy importers could view an allocation to energy stocks as a way to navigate an inflationary environment. Another reason to increase one's exposure to energy is improving fundamentals.
More favorable supply/demand dynamics have led to a strong run by energy stocks during the second half of 2017. Since mid-August, only the technology sector has generated higher returns. One driver has been OPEC's newfound discipline; the cartel's daily production has fallen by 4.5% since November 2016. Improving fundamentals in the U.S. have also contributed to a more bullish outlook as inventories have fallen by more than 14% since March.
Recently, the price per barrel of Brent Blend, the global benchmark, has eclipsed $60 for the first time in nearly two years. Despite the recent rally, some of the sector's most beaten-down names remain well below their five-year highs, and an improving outlook, in our view, may prove compelling to other large investors should Norway choose to sell its positions.
Given the size of its equity portfolio, Norway stepping away from energy would have short-term market ramifications. But we believe that turbulence would be limited as other buyers would find the sector's risk/return profile attractive, especially given the operational efficiencies that management teams have gained in the wake of 2014's crude price collapse.
Brent Blend - Brent Crude is a mix of crude oil from 15 different oil fields in the North Sea. It is the primary benchmark used for international oil prices.
The energy industries can be significantly affected by fluctuations in energy prices and supply and demand of energy fuels, energy conservation, the success of exploration projects, and tax and other government regulations. A concentrated investment in a single industry could be more volatile than the performance of less concentrated investments and the market as a whole.
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