Research in Focus: Energy’s surprise rally

Last year, markets worried that faltering demand for oil – whether as a result of slowing economic growth or the green energy transition – would weigh on shares of carbon-focused energy companies. But in 2024, energy has been among the top-performing sectors in the S&P 500^® Index, keeping pace even with high-flying tech stocks.

The reason: crude prices. In the early weeks of April, Brent crude traded around $90 per barrel, up nearly 30% from its 2023 low, helping to boost the revenues of oil-and-gas companies. And the pressure on prices could continue for much of the year as a result of supply/demand dynamics. Tensions in the Middle East and the ongoing Russia/Ukraine war, for one, have raised concerns about a supply shock. The Organization of the Petroleum Exporting Countries also extended its 2.2 million barrels-per-day cut in oil production through the second quarter of 2024. On the demand side, oil consumption has been surprisingly resilient, thanks to the strength of the U.S. economy.

Investor takeaway

In a tech-dominant market, the energy sector could offer investors a way to add diversification to a portfolio – at an attractive price. The sector trades at 12.3 times the next 12 months of estimated earnings, nearly half that of the S&P 500 Index. Furthermore, chastened by the U.S. shale-boom days of excess spending, many oil and gas companies are now focused on returning capital to shareholders via generous dividends and stock buybacks, rather than growing at any cost. And should interest rates stay higher for longer in the U.S., these healthy cash balances could make energy stocks appealing. Indeed, energy has traditionally been viewed as a hedge against inflation, which is another feather in the sector’s cap, given upward pressure on prices in the U.S.

All that being said, energy shares are notoriously volatile. While we believe there’s still room for potential upside, investors will want to keep in mind that a sudden drop in crude prices can result in energy stocks also falling. (Indeed, we have seen an easing in oil prices and energy stocks in recent weeks.) In addition, some areas of the sector have not participated in this year’s rally, in many cases for good reason. For example, services companies – those firms that provide equipment and services for oil producers – are facing the double whammy of higher labor and input costs and falling demand as oil production stays generally flat.

As such, we believe investors should focus on upstream oil and gas producers. In addition to benefiting from elevated oil prices, many of these firms have free cash flow yields that are double that of the S&P 500 while trading at a discount to the Index. Importantly, as discussed earlier, a significant portion of that cash is being returned to shareholders via dividends or stock buybacks, helping mitigate concerns of reinvestment in unwarranted supply growth. Balance sheets for most producers are also strong, which should provide support if we see oil prices retrace from recent highs.

Many refiners are also generating sizable cash flows, thanks to healthy refining margins (the difference between the value of petroleum products that refiners produce and raw input costs). As such, these companies have been able to increase dividends and repurchase shares, helping drive growth on a per-share basis. Disruptions caused by the Russia/Ukraine war create a near-term tailwind for refiners, but we also believe mid-cycle margins for U.S. refiners have structurally moved higher compared to prior cycles, thanks to improved operations and cost advantages. And while new refining projects are due to come online in Mexico and Nigeria in the next few years, this incremental supply is unlikely to outpace global growth in oil consumption, as forecast by the U.S. Energy Information Administration.

IMPORTANT INFORMATION

Energy industries can be significantly affected by fluctuations in energy prices and supply and demand of fuels, conservation, the success of exploration projects, and tax and other government regulations.

Concentrated investments in a single sector, industry or region will be more susceptible to factors affecting that group and may be more volatile than less concentrated investments or the market as a whole.

Diversification neither assures a profit nor eliminates the risk of experiencing investment losses.