Cyclical sector managers must avoid ‘buy and hold’ mentality
Richard Robinson (pictured) manages the Ashburton Global Energy Fund.
What scares many investors away from cyclical sectors – including consumer cyclicals, basic materials, financial services and energy – is the fear of performance blowouts when the business cycle turns. This is why cyclical stocks should never be bought with a ‘buy and hold’ mentality. Investors in these sectors must be active in managing through a cycle.
In our specialist sector, energy, there is one clear driver to consider – the oil price. However, the energy complex also has a range of sub-sectors – each reacting to the oil price in different ways.
Firstly, there are high sensitivity ‘upstream’ sub-sectors, which are closest to the source of oil production – including seismic, drilling, service and exploration and production. There are also the relatively low sensitivity ‘downstream’ sub-sectors – such as shipping, pipelines, refining and the major oil companies.
Taking exposure to a cyclical sector, such as energy, through a passively-managed ETF is not a sustainable option. A portfolio tracking the benchmark exposes investors to large weightings of high oil price sensitive areas at the top of the cycle, while reducing it at the lows.
Exposure to these ‘upstream’ subsectors hit almost 40% during oil price peaks of 2011 and 2014, while the same subsectors fell to 29% during the energy sector’s lows in 2016. If investors adopted a passive approach, their allocations to high and low sensitivity parts of the market would be the exact opposite of what is desirable.
It is clear highly cyclical sectors should be managed in a different way to low cyclical areas of the market. In the energy space, managers must place a six to twelve month directional forecast of the oil price at the very core of the investment methodology and be active in utilising the sub-sectors.
Energy entering an exciting phase
The energy market is currently entering an interesting and exciting period. After years of shrinking cash flow – with the resulting decimation of capital expenditure on long-cycle oil supply projects, which take four to eight years to start production – the market has cleared its excess oil inventories.
The market is now entering a period when activity has to be extremely strong in order to balance what increasingly seems like an undersupplied market.
We are approaching a time when the market desperately needs oil with a short lead time. Short-cycle oil, currently being produced from onshore US basins, can fit the bill.
Thanks to some incredibly strong productivity gains over the last five years, short-cycle oil has moved from being one of the most expensive to one of the cheapest sources of oil – outside of OPEC. In the offshore space, such as the North Sea, production is contracting in order to balance the market.
The US stands to garner much of the market share growth on offer over the next five years and investors should be looking to exploit growing areas such as the Permian Basin. The Permian Basin has the capacity to increase supply by 10-25% annually over the foreseeable future, without creating oversupply.
However, even with strong US activity, time appears to be against the industry and the market is looking undersupplied as we move towards the end of the decade.
Therefore, investors seeking to capitalise on the value on offer in the energy sector should gravitate towards high oil price sensitivity areas of the market to maximise the rewards during this strong phase of the cycle.