By Michael McCarthy

The Australian share market burst through previous highs last week. The strength of the market took many by surprise, including this writer. In one of those market ironies, the strength is at least partly a result of defensive positioning, leading to a melt-up where investors scrambled to top up their portfolios. Investors pondering what to buy could turn to the energy sector despite highly volatile oil prices.

Defensive share portfolios are a fact of post-GFC life. Healthcare stocks are popular for their assured income streams as populations age and governments pay the bills. More assured income streams also make utility and property stocks desirable. Dividend yield stocks such as banks and telcos are over-represented in portfolios as they allow investors to receive income as they ride-out any market storms. 

The reverse is also true. Investors are generally underweight more growth exposed stocks, such as miners and industrials. Many investors weigh the potentially higher returns from these sectors against the higher risk, and opt for safety. However, this ignores another investment risk – under performance. Whether tilted too far to defensive stocks, or heavily overweight cash, investors without growth exposures will lag their peers in an accelerating growth environment.

Some investors are well advanced in a portfolio rotation to growth. They saw the low points of 2016 as the bottom of the commodity cycle and bought resource shares. While many resource stocks are well off their lows, there is still potential upside, especially if commodity prices keep tracking the global economy higher.

This brings us to the energy sector. Oil and its derivatives power the world. Despite the rise of renewable energy sources - and the desire to move to a carbon dioxide reduced environment - there are no viable replacements for cool and coal so far. The one form that can compete, nuclear energy, is politically unpalatable.

After the high volatility of Q1 2016, oil prices have recovered. The charts show a price range for WTI crude, with major support around $42 a barrel and resistance at the recent highs around $56. There are fundamental factors supporting this range. Above $50 a barrel, US shale producers spring into action. Below $45, many producers are unprofitable and OPEC gathers support for limiting supply. While there is an element of elasticity to these reactions, they are likely to contain oil prices for some time.

This top side limit is sowing the seeds for the next oil boom. Major investment in exploration and drilling is unlikely while this perception remains. Large US inventories and desperate national producers mean this is probably years away, but it will surprise markets when/if it occurs. 

Perhaps more important is the potential for LNG. Gas is cleaner to burn and much cheaper to produce than most other energy forms (coal is the cheapest and dirtiest). It’s why, in my opinion, gas is the answer in a carbon-constrained world. And it's why I favour Oil Search and Woodside in the Australian energy sector.

 

This chart tracks the performance of Oilsearch, Woodside and Santos over the past eighteen months. The background is the oil price. Over the period, the price of oil is up 20%, yet the performance of these three key energy stocks is wildly disparate. Oilsearch is up 16%, Woodside is close to flat and Santos is down 26%. 

This difference in performance is partly attributable to individual company factors. An investor’s choice between these three could reflect different investment approaches. Some may argue that Santos is a value proposition, given it’s under performance. However, I prefer Oil Search as I see it as a higher-quality play. Woodside is also one of my favoured picks, but may face risks from politicians looking to plug budget deficits.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.