What Clients Are Asking: Oil, Iran, And the Path Forward

Sean Kenney:

Hi. We've received a lot of questions from our advisor clients that are coming from their clients about what's happening in the energy sector. So to unpack some of those questions, we thought we talked to one of the experts in the building here at MFS, Elizabeth McGuire. Elizabeth is energy sector team leader for MFS and is one of our resident experts and really understanding what's happening in the energy sector.

So Elizabeth, thank you for joining me. What we thought we would do is go through a couple of questions and frame some of the important conversations that our clients are looking to have with their clients. And, Elizabeth will help us provide some insights.

So I'm going to jump right in and ask a couple of quick questions and how we can, wrap on a on a high note. The first question is many of our clients ask about the price of oil, the amount of, barrels the U.S. has to stockpile in a conflict like this. But we're not commodity traders. Where long term investors. And so as a long-term investor, given that oil is so volatile, how do we think about oil and gas prices as we value companies along the energy complex?

Elizabeth McGuire:

Yep. Yeah, no, it's a great question because obviously the commodity price, as fundamental analysts, our job is to kind of forecast how much money a company is going to earn and that number is wildly variable depending on whatever the price of the commodity ends up being. So we try to standardize by using a mid-cycle price for the commodity and we'll have what we call a mid-cycle price deck where different analysts who cover different pieces of the chain will kind of standardize their valuation models on that $70 oil or $4 gas, $15 crack spreads in refining. And that's kind of how we'll look at valuation on those prices, not necessarily spot price or what the forward curve is saying and anything like that.

Sean Kenney:

Okay. So you mentioned we tend to use this long term average rate. Do we ever change that? What would cause us to change that assumption in the models?

Elizabeth McGuire:

Yeah. When there's structural changes to industry fundamentals that we think will be persistent, we would absolutely change that. And we would not change it if the spot price goes up due to like a temporary change. So we have been thinking over the last month, there's two kind of pockets of energy where some of the changes we're seeing we think may be longer term and more structural in nature and lead us to kind of change that mid-cycle valuation framework. And it's not actually related to the price of a barrel of oil. LNG is one area where we have seen supply destroyed in Qatar and supply that was being planned to come on over the next few years that'll be delayed as a result of the conflict. So perhaps placing greater value on North American LNG assets than historically and potentially a structurally higher LNG price than we had been thinking a month ago.

So that's one area we had our energy team meeting this morning on the topic of LNG and there's kind of pure play stocks and that's something a commodity all the majors, many of the majors produce as well. So that's one area where we think there might be a longterm structural change occurring. And then the other area I would point to is in refining where implications from both Venezuela and Iran in that there it's the mid-cycle crack spread when they kind of crack a barrel of oil that we talk about where the barrels of oil coming out of Venezuela are kind of higher margin, better mixed barrels for the refiners.

And now they're kind of coming to us and less of them are going to China. And then in Iran, higher gas prices as a result of that conflict mean the European refiners have kind of a steeper cost curve, which will raise the global kind of price for refining. Again, putting more value on North American refining assets. So those are kind of two areas where we think this could be longer term in nature, even if the price of oil kind of heads back down.

Sean Kenney:

Okay. So it's fair to say, I mean, we're long term investors. We think about these investments over long periods of time, but we're not putting our heads in the sand around the price of oil. It's something that gets factored in, but we're looking at the longer term structural impacts before we change models and assumptions. Fair?

Elizabeth McGuire:

Yep.

Sean Kenney:

Okay. And then the last question I have is around the impact of energy prices is impacting a few things. One is just the amount of money in people's pockets to do things like discretionary spending and travel and leisure, but it's also increasing the price of energy and oil for the aerospace industry. And as an analyst on the aerospace industry, I'd be curious how you think about that. And again, are these transient risks or are these more long-term sustained things that you think about in the portfolios?

Elizabeth McGuire:

Yep. So the higher price of jet fuel absolutely matters for aerospace stocks. Primarily, I guess we think the impact will be felt most in the aftermarket, so less so on the original equipment, aerospace side, but the commercial aftermarket for aerospace has been running very hot since the years immediately post pandemic, as some of the original equipment providers have struggled to return production to pre-pandemic levels. So we have a very old fleet that's been spending a lot on maintenance. And now with a higher price of oil, negative impact to airline profitability, we could see kind of less maintenance spend, or at least the rate of growth in maintenance spend slow down. So I'd say commercial, and I would add those stocks trade at pretty premium valuations. So any kind of wobble in fundamentals would have an outsized impact on the stock price.

Sean Kenney:

Okay. And what about what you're seeing in terms of demand for travel into regions like the Middle East, for example, which has historically been a pretty high demand travel area?

Elizabeth McGuire:

Yep.

Sean Kenney:

What are you seeing there?

Elizabeth McGuire:

Yeah, air traffic in the Middle East is definitely down, and that is a huge pocket of growth for air travel if you look at the rate of growth there relative to other parts of the world. And so it's also an area where if we talk about kind of aerospace engines are a huge part of the aftermarket, it's hot, it's harsh. Engines that operate there require more maintenance. So kind of an outsized impact there due to that. And again, this is about duration and if oil prices go back down tomorrow, potentially not a cataclysmic scenario for these companies, but it's, I would say for an industry that's been very strong fundamentally for several years now, giving us a moment of pause, I would say.

Sean Kenney:

And a theme that you're looking to implement in portfolios for clients.

Elizabeth McGuire:

Yep, absolutely.

Sean Kenney:

So we've talked about a couple of things. Is there anything that we haven't touched on that you think our clients would have interest in?

Elizabeth McGuire:

Yeah, I would just say on the last aerospace point, we have been kind of leaning more towards the original equipment suppliers in our positioning for years now and for this expectation that the aftermarket would slow. And I'd say this is, if anything, just kind of accelerating that or kind of amplifying that positioning.

Sean Kenney:

Okay. Well, thank you for the time. Thank you for the insights and we hope that's helpful for you. If your clients are asking you questions that you want more information on, please reach out to your MFS wholesaler. We're happy to provide the information you need to serve your clients. Thank you for the trust and confidence in MFS and we appreciate the partnership.

 

 

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