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Martin Tillier

Martin Tillier

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Should Energy Investors Be Worried By The Fed’s Latest Move?

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Just in case you didn’t notice, stocks lost ground yesterday, and the reason du jour was a surge in interest rates. The yield on the benchmark 10-year T-Note climbed to around 3.2 percent, its highest level in years, and the jump extended out along the curve with the 30 year also hitting its highest level since 2014. That put pressure on stocks as traders weighed the potential slowing effects of higher rates on the economy and the fact that higher yields make bonds relatively more attractive, potentially diverting money from the stock market. The question here, though, is should energy investors be concerned?

Figure 1: 10 Year T-Note Yield

(Click to enlarge)

People are attracted to investing in the energy sector for several reasons, but recently one of the main among them is the lack of correlation between stocks in the sector and the broader market. Energy stocks respond more to moves in the price of oil than they do to anything else, so don’t necessarily follow the herd. In order to assess the potential impact on those stocks of higher yields then, we must first look at what it could mean for oil prices.

There seem to be several reasons rates jumped yesterday. The most obvious is that the Fed is hiking short-term rates, but that has been the case for a while and their plan to continue along that path can hardly be called a secret. More likely this was a move in front of today’s jobs report which was expected to show higher average wages, something that is often an indicator of future inflation. The belief is that that could prompt the Fed to increase the magnitude and pace of rate hikes and the market is discounting that possibility. Once again, though, the relevant question here is how will that affect energy stocks?

Related: Why The Saudis Can’t Keep A Lid On Oil Prices

If inflation is at the root of concerns, then far from being a negative for the sector, the events of the last couple of days should be a positive, at least in the relatively short term. Inflation means rising prices, and the price of oil should go up along with everything else. As I said earlier, the price of oil is one of the main drivers of energy stocks, so if that moves higher, stocks will follow. We are already seeing high prices because of supply constraints, so another jump should result in a windfall for oil companies.

Traditionally, rate hikes have been seen as bad for energy stocks because much of their value, at least in the case of the big multinationals, has been derived from dividend payments. However, following the collapse in oil prices a couple of years ago dividends have been cut in many cases, making them less of a factor for energy investors. So, while higher rates will push the price of yield-focused investments such as MLPs lower, they will probably have a muted effect on other oil stocks in terms of relative yield.  

However, the picture becomes a little less rosy if we look a little further into the future. Rate hikes are necessary to counter inflationary pressure, but they are not without some risk. Higher interest rates discourage borrowing and investment, slowing the economy down. If they are overdone, even by a small amount, that could choke off the energy demand growth that the market is currently pricing in, forcing oil, and therefore energy stocks, lower.

The answer to the original question, should energy investors be concerned about rising bond yields, is therefore yes and no. In the short term, the inflation that the move is anticipating will be a positive, but in the long term, slower growth could have a negative effect. In those circumstances, as stocks fall in response to higher rates, buying energy stocks makes sense, at least for now, but investors should stay alert for signs of a reversal.

By Martin Tillier for Oilprice.com

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