Morgan Stanley Has Given Up on Energy Stocks

Here's why.

Transocean Biggest Winner From 28% Jump in Oil Rig Rates

The oil rigs were rigged.

Photographer: Derick E. Hingle/Bloomberg

Toward the beginning of 2015, with crude oil prices in free fall, Morgan Stanley's equity strategy team made a bold call, upgrading the energy sector to overweight.

But there's been no reprieve for those stocks this year, with the S&P 500 energy sector index losing nearly one-quarter of its value year-to-date:

Bloomberg

Now, in a display of candor that's rare on Wall Street, chief U.S. equity strategist Adam Parker is waving the white flag.

"We made a really bad call by going overweight energy at the beginning of this year," he wrote.

Morgan Stanley downgraded the sector to market weight, indicating the supply glut in oil may not improve for another year, at a minimum, and that investors will likely find a better entry point in six to nine months.

In rationalizing the downgrade, Parker adapted a phrase often attributed to John Maynard Kenyes: "When the facts change, I change my mind. What do you do, sir?"

There's been new information "… since the original upgrade and our judgment is, why hold a losing bet when we have new information?" wrote Parker, noting that the full effects of the shale revolution are now being crystallized. "Companies can make the same margins at $60 oil today as they could at $90 oil a couple of years ago."

The strategist recounted how his dream scenario in energy turned into a nightmare:

Our original thesis when we went overweight the energy sector at the beginning of the year was that they were cyclical stocks that were down a lot, you had to be anticipatory and the valuation was compelling. We thought the falling rig count would be a catalyst to spark a dream of higher oil. Well, we now think rig counts aren’t the way to think about it. It is production, and production isn’t down really at all in the US. While the sector rallied in February and March in anticipation of achievable estimates in April, the sector has lagged massively since because of stronger than expected supply. The valuation argument only works with a dream of a much higher oil price in the future, and that dream has been a bit of a nightmare.

A scary thought for the remaining oil bulls: Parker posits that oil is perhaps much more like natural gas than is currently acknowledged, implying that meaningful upside from current levels might not be on the horizon. The futures curve for West Texas Intermediate is sending a similar signal, with contracts through 2023 priced below $60 per barrel.

But in the same breath as he lowered his rating of the sector, Parker expressed concern that he's making this call at exactly the wrong moment.

"We are clearly burned by our wrong overweight, and worry that this downgrade could be the beginning of an energy rally," he wrote. "It always stings to get it wrong in both directions."

What might give Parker renewed nightmares: After its explosion and resilience in the face of falling rig counts, U.S. crude oil production is showing some signs of rolling over.

Bloomberg

Being long and wrong on energy stocks didn't hurt too much, said Parker, because the team's stock selection within the group was wise, and the sector still didn't make up a large part of their portfolio.

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