Energy Sector Rating: Neutral
Amid the ongoing global energy crisis, the Energy sector has outperformed the overall market since the COVID-19-crisis-related market lows in March 2020. Nevertheless, it is still one of the worst longer-term performers—despite crude oil recently trading at 14-year highs—as the clean energy movement and associated regulatory risks have loosened the sector's historical relationship with the price of oil. As the energy transformation advances, many companies in the sector haven't ramped up capital expenditures and production along with rising oil prices, as they have done historically. The silver lining is that if there were a significant decline in oil prices, they will be less exposed to stranded assets (investment that becomes obsolete).
Valuations in the Energy sector are attractive relative to the other sectors. Despite the strong gains in energy stock prices, they have not kept up with rapidly rising earnings expectations. This is not surprising, as investors have remained wary of the boom/bust sector and energy transition, while equity analysts found optimism amid the combination of rising oil prices boosting revenues and restrained expense growth.
Meanwhile, oil inventories have declined. With the reopening of the global economy and the restrictions on oil imports from Russia, the recovery in demand for oil has outstripped supply by cautious producers—OPEC and U.S. producers alike—driving inventories lower. A continued decline in inventories against the backdrop of relatively higher demand is inherently supportive for oil and potentially energy companies.
However, numerous uncertainties surround the price of oil, with the potential for renewed OPEC disagreement, slowing economic growth in China, rising tensions amid Russia/Ukraine war, and potentially harsh regulations related to the transition toward clean energy.
The Russian invasion of Ukraine in late February, and the ongoing political response, has clouded our outlook on equity sectors. Due to the unprecedented and volatile series of events, the economic and market landscape has become highly uncertain.
Until there is more clarity on how the sharp rise in commodity prices, tightening of financial conditions, and likely Federal Reserve interest rate hikes might impact the economy and underlying fundamentals that drive relative sector performance, we think it’s prudent to maintain sector allocations that are in line with the overall market.
Positives for the sector:
- Oil prices are being supported by improving demand and the Russian/Ukraine war curtailed supply and drawdown in inventories
- Large, diversified energy companies have strong balance sheets and have become more disciplined with expense and investment management—though the high price of oil could erode this self-control
- Valuations are attractive relative to other sectors
Negatives for the sector:
- Oil prices may have reached a level that could weigh on the economy and demand for oil
- The global economic expansion appears to be slowing, which could weigh on this highly cyclical sector
- OPEC could release extra supply to address limit the rise in prices
- The strong U.S. dollar is inconsistent with recent strength in oil prices
- Increasingly onerous regulatory environment—though implementation is likely to be measured
- U.S. oil and gas majors have been slow to shift towards clean energy—but potential subsidies might encourage greater adoption of renewables
- Shareholder activism has risen
Risks to the sector:
- Aggressive Fed rate hikes could result in a recession and depress demand for oil
- De-escalation of the Russia/Ukraine war, easing in Iranian sanctions, and/or a big increased oil production could increase oil supply and weigh on prices
- OPEC could release extra supply to address limit the rise in prices
- Numerous risks to global growth stemming from the COVID-19 pandemic or geopolitical flareups
- A significant rise in market volatility and rise in the U.S. dollar
- Trend toward clean energy to reduce oil demand in the long term
- Weakening Chinese growth could reduce oil demand
What do the ratings mean?
The sectors we analyze are from the widely recognized Global Industry Classification Standard (GICS®) groupings. After a review of risks and opportunities, we give each stock sector one of the following ratings:
- Outperform: likely to perform better than the broader stock market*
- Underperform: likely to perform worse than the broader stock market*
- Neutral: no current view on likely relative performance
* As represented by the S&P 500 index
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