Embracing energy market volatility

Energy investing means expecting – and even exploiting – volatility. Knowing how to take advantage of opportunities across energy market cycles can help investors meet their long-term goals. CIO Mike Kelly explains how to make the most of volatility.

Mike Kelly
November 15, 2017 | 5 minute read

Hurricane-related outages. Production cuts. Iraqi-Kurdish conflicts. These are just a few of the headline-worthy events that impacted oil prices in October. In June, oil prices dropped to a 2017 low and, within a few months’ time, closed in on a two-year high. This rocky landscape is nothing new to those who invested in energy the past few years. To some, the peaks and valleys of energy market volatility create a great deal of anxiety. To others, those same ups and downs spell opportunity.

To get a better view of the sector’s variability, let’s wind the clock back a bit further. Today’s volatility is the latest in a series of oil price declines we experienced in the last several decades. Each decline – stemming from the supply expansion in 1985, the Russian ruble crisis of 1998, the start of the Iraq War in 2003 and the financial crisis of 2008 – came with elevated volatility and a disparity of returns across energy subsectors and asset types. If history is any guide, we’ll see booms and busts punctuated by periods of shorter-term price volatility in the years ahead.

Simply put, they don’t call it a cyclical commodity for nothing.

Tapping into a vital sector of our economy

​Since volatility in the energy market is pretty much a given, we need to ask, why is investing in the energy market worth the risk and how do we make its volatility our friend? To help answer these questions, it’s important to consider the market’s nature, size and scope.

Let’s start with the obvious. Billions of people depend on energy every day, and as world populations grow, so does demand. Energy investing supports crucial exploration, development and supply of a basic necessity of life. That the energy market is both huge and complex is no surprise, but some of the details around that reality might be. There are over 21,000 U.S. energy and power companies operating in the United States and around the world, and they account for about $6 trillion worth of investable assets.¹ That figure should get our attention – it tells us the opportunity in the energy industry is more than just investing in commodities like oil and gas.

The operations of these American companies are broad and diverse, extending across the upstream, midstream, downstream, services and equipment, and power subsectors. As the mosaic below shows, performance of these energy subsectors can vary widely across the commodity market cycle. Over the past 10 years, for example, the difference in annual returns between the top and bottom subsectors averaged around 30%.²

To level out the peaks and valleys that will undoubtedly arise within the energy sector, allocating across energy subsectors and asset types, rather than relying on any one subsector, can help mitigate risk and offer an opportunity to generate higher returns over the long term. Note, the investment horizon is significant because of the cyclical nature of the commodity and the return disparity across subsectors and asset types. From our perspective, energy investing is for those who can stay committed to their plan for meeting long-term growth and income goals – especially when things get bumpy.

Annual returns for energy subsectors ranked in order of performance

Past performance does not guarantee future results. This data is for illustrative purposes only. An investment cannot be made directly in an index. As of December 30, 2016. Subsectors are represented by the following indexes: Energy services high yield: J.P. Morgan Domestic High Yield Energy Services Index; E&P high yield: J.P. Morgan Domestic High Yield Exploration & Production Index; Midstream high yield: J.P. Morgan Domestic High Yield Midstream Index; Pipelines high yield: J.P. Morgan Domestic High Yield Pipelines Index; E&P equities: S&P 500 Oil & Gas Exploration & Production Sub-Industry Index; Midstream equities: S&P 500 Oil & Gas Storage & Transmission Sub-Industry Index; Energy services equities: S&P 500 Oil & Gas Equipment & Services Sub-Industry Index.

View an interactive version of this chart on our energy investing page.

Making the most of volatility in energy

Knowing how to take advantage of volatility in the energy market can help investors generate attractive returns. Here are four things investors can do to try to make the most of it:

  • Focus on income. Energy and energy infrastructure companies may serve as a meaningful source of income as many midstream companies generate predictable cash flow through changing market cycles.
  • Be flexible. Since there is strong potential for wide differences in annual returns from one subsector and asset type to another, investing across subsectors and asset types (debt and equity) may help manage risk and take advantage of investment opportunities as they change over time.
  • Size your investments appropriately. Determining the appropriate size of an investment can help ensure that no single investment has an outsized influence on a portfolio’s performance.
  • Invest for the long term. The energy sector offers attractive income and growth opportunities based on strong long-term fundamentals, including rising global energy demand, the need to build and replace U.S. energy infrastructure and the continuous capital needs of energy and energy infrastructure companies to replace their depleting oil and gas resources.

Going into energy investing with your eyes wide open should translate into expecting – and even exploiting – volatility. While this can be challenging for even the most experienced investors, if managed effectively, this approach may result in opportunities across energy market cycles and their periodic corrections.

  • Bloomberg, FS Investments, as of March 2017. Excludes private company data.

  • Bloomberg, FS Investments.

This information is educational in nature and does not constitute a financial promotion, investment advice or an inducement or incitement to participate in any product, offering or investment. FS Investments is not adopting, making a recommendation for or endorsing any investment strategy or particular security. All views, opinions and positions expressed herein are that of the author and do not necessarily reflect the views, opinions or positions of FS Investments. All opinions are subject to change without notice, and you should always obtain current information and perform due diligence before participating in any investment. FS Investments does not provide legal or tax advice and the information herein should not be considered legal or tax advice. Tax laws and regulations are complex and subject to change, which can materially impact any investment result. FS Investments cannot guarantee that the information herein is accurate, complete, or timely. FS Investments makes no warranties with regard to such information or results obtained by its use, and disclaims any liability arising out of your use of, or any tax position taken in reliance on, such information.

Any projections, forecasts and estimates contained herein are based upon certain assumptions that the author considers reasonable. Projections are necessarily speculative in nature, and it can be expected that some or all of the assumptions underlying the projections will not materialize or will vary significantly from actual results. The inclusion of projections herein should not be regarded as a representation or guarantee regarding the reliability, accuracy or completeness of the information contained herein, and neither FS Investments nor the author are under any obligation to update or keep current such information.

All investing is subject to risk, including the possible loss of the money you invest.

Mike Kelly

Co-President + Chief Investment Officer

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