Research Report: Energy’s surprise rally
Research Analyst Noah Barrett, from the Global Research Team, explains what’s behind the recent rise in energy stocks and what investors should consider moving forward.
4 minute read
Key takeaways:
- Energy has been among the top-performing sectors so far in 2024, thanks to strong demand for crude and limited oil production.
- The sector has continued to trade at a discount to the broader market, while favorable demand/supply dynamics could support the stocks for much of the year.
- Energy could be one way to diversify an equity portfolio and hedge against persistent inflation, but investors should be aware of short-term volatility.
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.
By the numbers – S&P 500 Energy Sector*
- 3.07% – Average annual dividend yield over the trailing 12 months.
- $91/barrel – So far, this year’s peak price in Brent crude (5 April). Some analysts believe prices could go higher as a result of strong demand and geopolitical tensions/production cuts.
- 12.3x – Forward price to earnings ratio, compared to 19.9 for the S&P 500 Index.
- 7.14% – Free-cash-flow yield. By contrast, the S&P 500 Index yields only 3.4%.
*Source: Bloomberg, as of 23 April 2024 unless otherwise noted.
Free cash flow (FCF) yield is a financial ratio that measures how much cash flow a company has in case of its liquidation or other obligations by comparing the free cash flow per share with the market price per share and indicates the level of cash flow the company will earn against its share market value.
Price-to-Earnings (P/E) Ratio measures share price compared to earnings per share for a stock or stocks in a portfolio.
S&P 500® Index reflects U.S. large-cap equity performance and represents broad U.S. equity market performance.
The S&P 500® Energy comprises those companies included in the S&P 500 that are classified as members of the GICS® energy sector.
Volatility measures risk using the dispersion of returns for a given investment.
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.
These are the views of the author at the time of publication and may differ from the views of other individuals/teams at Janus Henderson Investors. References made to individual securities do not constitute a recommendation to buy, sell or hold any security, investment strategy or market sector, and should not be assumed to be profitable. Janus Henderson Investors, its affiliated advisor, or its employees, may have a position in the securities mentioned.
Past performance does not predict future returns. The value of an investment and the income from it can fall as well as rise and you may not get back the amount originally invested.
The information in this article does not qualify as an investment recommendation.
Marketing Communication.
4 minute read
Key takeaways:
- Energy has been among the top-performing sectors so far in 2024, thanks to strong demand for crude and limited oil production.
- The sector has continued to trade at a discount to the broader market, while favorable demand/supply dynamics could support the stocks for much of the year.
- Energy could be one way to diversify an equity portfolio and hedge against persistent inflation, but investors should be aware of short-term volatility.
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