Title: Power Play – Energy Sector Upside Potential on Long-tail Transition

Target recording time: 3-5 minutes

Welcome to Canadian Insights, where Morgan Stanley Wealth Management offers the Canadian perspective on global macroeconomic events, while as always, adhering to a long-term approach.

I’m your host, Stu Morrow, Chief Investment Strategist for Morgan Stanley Wealth Management Canada.

In this episode I am going to focus on our most recent report titled “Power Play: Energy Sector Upside Potential on Long-tail Transition”.

For more details on our report, please visit our website at www.morganstanley.ca, or reach out to your Morgan Stanley Wealth Management Canada Financial Advisor with any questions.

Alright, let’s talk about why we believe a longer than expected transition to net-zero emissions will result in heightened oil price volatility, and how we think investors can prepare their portfolios for this scenario.

The transition route to Net-Zero Emissions established by the 2015 Paris Agreement may be a turbulent one given a curtailed supply of traditional energies, while demand has yet to fully adjust. On the other side of an energy transition lies a new, stable system, but the interim entails risks that, we believe, can be hedged with continued exposure to the energy sector.

We expect that alternatives to fossil fuels will eventually scale to compete with traditional energy sources, but the transition period may take more time than the market expects. In the meantime, over the coming decade, we expect an imbalance between the demand and supply of oil may result in heightened oil price volatility.

On the demand side for oil, we do believe that the growth in electric vehicles may erode oil’s dominant share of the global energy market, but over a longer than expected period. We’re not disputing the merits and eventuality of a dominant electric vehicle fleet. We only take issue with the expected timeline to get there.

Here are four considerations for investors:

First, it may take some time for electric vehicles to become a meaningful share of the global auto fleet. The replacement cycle for internal combustion engines may be longer than most expect. In Norway, for example, where electric vehicles have exceeded the country’s 60% target of new car sales in 2022, electric vehicles made up only 12% of the cars on the road, and total oil consumption remains unchanged.  

Second, the scarcity of many industrial metals required for electric vehicle production have led to their own supply and demand asymmetries. We believe this could further slow the transition towards net-zero emissions.

Third, the infrastructure required to support a growing fleet of electric vehicles shouldn’t be underestimated. Additional public and private sources of capital need to be committed to upgrading transmission pathways. Fiscal budget restraints and existing high levels of debt outstanding may be headwinds that elongate the transition period.  

And finally, the uncertainty associated with the current outlook for monetary policy, which could mean higher for longer interest rates. Changes in rate expectations could also result in the delay or cancelation of infrastructure and mining projects needed to meet net-zero emission targets.

On the supply side of the oil market, oil and gas producers have, amongst other reasons, reduced capital expenditures over the last several years because of net-zero emission targets around the world.

According to the U.S. Energy Information Administration, the global supply of oil is expected to decline faster than the decline in demand for oil. Since oil and natural gas are depleting resources, underinvestment over the long-term may result in higher price volatility for the commodity.

Furthermore, geopolitical risks may only serve to further price volatility for oil over the near and long-term.

In terms of investment decisions, we believe that investors can participate in the energy transition with exposure to Canadian Energy.

We believe that Canada’s Oil & Gas industry can play a critical role in energy transition over the coming decades despite a less enthusiastic view from the market.

Growth investments in new cleaner-energy businesses are in the early stages for most, but supportive policy could allow them to scale more rapidly (and economically) than expected.

Valuations in the Canadian energy sector already suggest a pessimistic outlook related to the future demand for oil and gas, and current valuations do not reflect the potential for growth related to growth investments being made in technology that reduces carbon emissions.

Fundamentally, the Canadian energy sector has shown capital discipline over the last few years, evidenced by market leading free cash flow yields, which provides investors with attractive dividend growth opportunities.

The good news for investors is a high price of oil isn’t required for Canadian energy producers to be sustainable.

Analysis suggests that the producers can sustain capital expenditures, meet future dividend payments, meet their net-zero emission targets, and retire their outstanding debt so long as prices remain higher than $65 per barrel (compared to the current price of ~$80 per barrel for WTI).

While we expect more price volatility for oil in the long-term, the sustainability of the sector above $65 per barrel provides perspective on the downside case for Canadian energy.

Furthermore, our analysis suggests that exposure to the energy sector may offer a portfolio hedge against the risk of persistently high inflation. Meaning the energy sector has historically been a complement to bonds within a portfolio.

Investors should consider their existing exposure to Canadian active and passive equity strategies before considering additional exposure to Canadian Energy. Please reach out to your Morgan Stanley Financial Advisor with any questions.

Thank you for listening. Please visit our website at www.morganstanley.ca for more information about our energy sector outlook.