During an Aug. 11 conference call on oil markets, analysts pointed out the upside for investors in the energy space: As valuations sit at their lowest levels since the ’70s, energy stocks have never been so cheap relative to other equities in the marketplace, David Lefkowitz, senior equity strategist at CIO Wealth Management Research Americas, said.

“The sector has become too cheap to ignore,” Lefkowitz said during the call. “This is, on some measures, the cheapest the sector has been in many decades,” which will likely lead to outperformance in the sector over the next six to 12 months, he said.

Still, investments in the energy sector and in MLPs in particular will require more consideration going forward than was needed when oil was above $100 per barrel.

“The group really traded together in sync for a lot of years. Even companies that should have underperformed did better than the regular market because there was so much capital in the space,” Shneur Gershuni, MLP & natural gas analyst with UBS Investment Research, said during the call.

“I think that we’re going to be a lot more discerning going forward,” he said. “We think that you really want to focus on organic growth,” especially in the right basins. Those include the Permian, the South-Central Oklahoma Oil Province and the Marcellus and Utica plays in the Northeast, Gershuni said.

Managing Expectations

Midstream MLP distribution growth should remain strong through 2016 as midstream development catches up with U.S. production that has contributed to a significant oversupply.

“The concern is really about 2017, that as E&Ps slow down their capex and their drilling there could be a growth gap in ’17,” Gershuni noted. Investors have been focused on that growth gap, but Gershuni explained that concerns there could be overblown.

“Non-OECD demand will continue to transition the U.S. toward exporting hydrocarbons in one form or another, and there are still plenty of basins where there are growth opportunities,” he said. “There are just some where there aren’t growth opportunities as well, and it’s important to distinguish between them and choose the right stocks to reflect that investment opinion.”

Gershuni cautioned that when evaluating a potential investment, certain performance criteria should have more weight than others.

“A lot of people like to look at the yield relative to the 10-year yield and say, ‘Wow that’s cheap. Look at that spread,’ ” he said. A more important factor is cash flow metrics. Of four MLP investments USB Investment Research recommended in a recent note, “three of them have growth rates that are greater than the multiples on cash flow that they’re actually trading at,” he said. “I would strongly focus on price-to-cash-flow.”

An Inevitable Rebound

Though the current oversupply is keeping prices down, the cycle of supply and demand dictates that the low price environment can’t last forever, Nicki Decker, senior energy sector strategist at CIO Wealth Management Research Americas, said.

“Because prices are so low there is very little economic incentive to invest in new developments, and over time supply growth wanes and the markets will rebound,” she said. This could occur as U.S. onshore producers cut back on their drilling programs, but market conditions could also force Saudi Arabia’s hand, she noted.

“At some point, the Saudis will be forced either by pressure from people not getting the services they were promised or their own government’s fiscal requirements to start protecting oil prices,” she said. While observers see ongoing growth in production from Saudi Arabia, “the Saudis say we reduced production by 200,000 barrels per day in the month of July,” she said.

“Perhaps they’re already seeing that they have to start making room here and supporting prices.”

Contact the author, Caryn Livingston, at clivingston@hartenergy.com.