What a capex boom means for energy

From semiconductors to lumber, supply shortages across many industries have been a well-observed outcome of an economy firing on all engines. 

As businesses work to keep up with accelerating demand, they are investing in new production facilities and other large capital expenditures—known as capex—a trend that Morgan Stanley Research expects will continue to drive the next leg of economic growth. In fact, they anticipate investment rising to 116% of pre-recession levels over the next few years.

In times like these, the energy sector has historically benefitted from surging business investment. After all, it requires energy to build products, operate facilities, and increase production output. In addition, trends in the energy sector are shifting in meaningful ways that may benefit intrepid investors.

To assess which sectors stand to potentially benefit most from a surge in capex, Morgan Stanley Research recently analyzed 40+ years of data across more than 60 industries. They found energy industries placed among the top ten in terms of sales growth relative to the rest of the market when capex outgrows the economy. Energy equipment and services, as well as oil, gas, and consumable fuels came in at numbers four and nine, respectively. In short: When investment intensity picks up, sales for the energy sector tend to rise with it. 

Historically, that's been especially true for the energy equipment and services industry, where the strongest correlation came from increased investment in structures such as exploration shafts and wells. As oil producers invested to meet their demand, sales for equipment and service providers also grew incrementally. 

In the current cycle though, public upstream producers (think: exploration and production, or “E&P”, and integrated oil companies) may restrain capital spending, boost cash reserves, and reallocate to energy transitions—meaning that the drivers of growth in equipment and services spending may instead come from national oil companies.

An improving global outlook is also important: The energy sector is cyclical at its core, meaning demand typically rises in concert with global growth.

A critical aspect to the capex story for the oil and gas space is how companies manage their cash flow. After demand plummeted in 2020, many energy companies were forced to take a more disciplined spending approach to conserve cash—a practice that appears to be sticking even as demand improves and oil prices rise.

Given this backdrop, excess cash may be directed towards debt reduction and shareholder returns, whether through dividend increases, share buybacks, or credit rating increases.

Over the past decade, the energy sector has underperformed the broad market amid a proliferation of oil supply, long-term concerns about energy transitions, and the rise of sustainable investing. While these dynamics may continue to influence the sector’s performance, new markets may emerge to fill the gap that's been left by traditional oil and gas spending.

Companies that take a proactive approach to managing climate risks may be better positioned in the sector going forward. That doesn't just apply to upstart challenger companies. Traditional oil companies with an eye for innovation may enjoy competitive advantages as they scale decarbonization technologies. For example, economies of scale may bring technologies like carbon capture, renewable fuels, and hydrogen technologies into a more cost-competitive position.

Bottom line: Capex intensity has historically been a tailwind for the energy sector—but one that needs to be considered against other factors as well, including a slowdown in the rapid rise of both oil prices and inflation. Selectivity and diversification may be increasingly important in this evolving landscape. 

The source of this article, Return of Capex: Energy, was originally published on June 18, 2021.