On the Radar: An Energy Boost for Stocks?

This is the third in a series on longer-term market influences. Each has considered what developments could help or hurt the equity rally after some 18–24 months, when, in all likelihood, stocks will fully realize their still attractive existing valuations and feel the last effects of the ongoing flood of liquidity provided by the Federal Reserve. The first number in this series took up monetary policy and the second fiscal reform. This last discussion looks at the prospect of energy abundance, due to fracking, among other sources.

This article concludes that energy abundance, though it holds out the promise of generally improving earnings and raising valuations on financial assets, is probably too distant to play much of a role within this time horizon. If the rally were to extend for the longer term, it will need some other favorable fundamental development to sustain it. Energy abundance, for all its exciting promise, will have its effect only over a longer time horizon.

The appealing elements of the long-term energy picture are certainly evident. The fracking revolution in the United States has received most of the media attention. It promises by 2020 to make this country a bigger oil and gas producer than Saudi Arabia. But there are other regions where fracking holds promise. Brazil, for example, is developing its significant new find in the South Atlantic. Canada continues to exploit its shale and tar sand deposits. Australia reports a major shale discovery. Combined, these sources promise to raise known petroleum reserves by almost 20%. Meanwhile, Exxon is applying new exploration technologies to support its drilling in the Russian Arctic, with, its geologists and engineers report, excellent preliminary indications. And shale deposits in Western Europe and China offer a promise so new that engineers and geologists have not even quantified the potential.

Ultimately, when these new sources begin to flow into global energy markets, they will have powerful positive economic and market effects. The new energy abundance will depress energy prices and, in the first instance, increase corporate profits in just about every sector except the oil majors. Declining energy prices will also increase consumers' abilities to spend on other products or save more than previously. All of this will accelerate the pace of economic growth. Perhaps even more important, the newly discovered energy sources will, when they are fully developed, diversify the world's dependence away from the unstable regions that currently dominate the market and the Organization of Petroleum Exporting Countries (OPEC), in particular the always volatile Middle East and politically unstable Venezuela. That improved reliability will enable energy consumers—individuals and businesses, large and small—to plan more effectively than in the past—a fact, once it becomes evident, that will enable markets to place higher valuations on financial assets. This consideration and the brute fact of lower energy costs will also reduce inflation risks, separately promoting higher valuations.

Promising, supportive, and even probable as all this is, it is still a rather distant prospect, especially in the context of the current rally. Brazilian oil company Petrobras has years of development in front of it before it can bring the South Atlantic oil to market. For all the great strides noted by the media about oil and gas extraction in the United States, this country's gas and oil transport facilities remain inadequate, as do export facilities, not the least because all the port facilities were constructed for energy imports. For all the promise of the Russian Arctic, Exxon has yet to announce a major find, and, if that seems relatively certain given company reports, it will take years to develop after the company discovers the reserves. Canadian resources are better developed, but the hugely promising Australia shale find is still in its exploration phase. In the meantime, the world's energy users remain largely dependent on the adequate but more limited and, critically, unreliable OPEC sources. Fully one-quarter of the world's oil still passes through the exceedingly tense Persian Gulf. It is this reality that explains why, for all the new finds, a barrel of oil today still costs more than $90 (West Texas Intermediate) when it might otherwise be closer to $60.

Financial markets have rallied despite this frustrating situation, because the Fed continues to pour liquidity onto them, and equities in particular still show attractive valuations, for reasons having nothing to do with energy costs. Unfortunately, the world will still be waiting for this bright energy promise some 18–24 months from now, when equities will likely realize the full potential of current valuations and the Fed will likely have begun to climb down from its present, extremely accommodative policies. The rally may persist, because the Fed does its job deftly, because Washington finally begins to address important underlying fiscal needs, or because some other fundamental improvement takes shape. But this bright energy future is still too distant to recommend itself as the underlying good news that might extend the rally then. To be sure, those exciting prospects will be closer in a year or two than they are now. Markets, always forward looking, will be more inclined than presently to price them into markets. But likelihoods suggest the effect will remain minor. The present equity rally will need to count on something other than the improved energy outlook.

A Note about Risk: The investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy.

The opinions in the preceding economic commentary are as of the date of publication, are subject to change based on subsequent developments, and may not reflect the views of the firm as a whole. This material is not intended to be relied upon as a forecast, research, or investment advice regarding a particular investment or the markets in general. Nor is it intended to predict or depict performance of any investment. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information. Consult a financial advisor on the strategy best for you.

© Lord Abbett


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