Is it Too Late to Jump in on the Energy Rally?
April 23, 2024
Oil prices so far this year have been on a tear, with brent crude and WTI gaining 18% year to date. This has been a sharp turnaround from 2023, where both benchmarks fell 3-4% for the year. Energy equities have mirrored oil’s trajectory, with the S&P Energy Sector Index dropping 0.6% in 2023 and gaining 14% so far this year. It is the second top-performing sector year-to-date, only trailing Communication Services (+16%) and beating out Technology (+9%). Several factors suggest the rally in Energy may have further room to run.
Oil prices have been buoyed by increased geopolitical tensions, highlighted by Ukraine’s recent attack on Russian oil refineries, and a sharp escalation in the conflict between Israel and Iran. Supply constraints have been driving energy prices as well. OPEC+ recently agreed to extend voluntary production cuts into the second quarter, while US production suffered a sharp drop earlier this year, due to extreme January weather and a 20% drop in rig count in 2023. Upcoming seasonal trends will be an additional tailwind for energy prices, particularly from March through the summer months, due to increased air travel and driving.
Furthermore, the recent hotter-than-expected U.S. CPI numbers make Energy attractive from an inflation-hedging perspective. From a valuation point of view, energy stocks (12.6x) are trading at a 40% discount to the broader market (20.9x) on a relative forward P/E basis, which is near decade lows. Lastly, oil companies have adopted a more shareholder-friendly approach to capital allocation in recent years. 2022 was the first time in a decade that more cash was allocated to dividends, buybacks and debt repayments, instead of on capital expenditures.
In conclusion, given that Energy acts as an inflation and geopolitical hedge, coupled with attractive fundamentals and valuations, the rally in oil and energy stocks may have more room to run.
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Investments in commodities may have greater volatility than investments in traditional securities, particularly if the instruments involve leverage. The value of commodity-linked derivative instruments may be affected by changes in overall market movements, commodity index volatility, changes in interest rates or factors affecting a particular industry or commodity, such as drought, floods, weather, livestock disease, embargoes, tariffs and international economic, political and regulatory developments. Use of leveraged commodity-linked derivatives creates an opportunity for increased return but, at the same time, creates the possibility for greater loss.
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The S&P 500 Energy Index comprises those companies included in the S&P 500 that are classified as members of the GICS® energy sector.
The Consumer Price Index (CPI) is a measure of inflation compiled by the US Bureau of Labor Studies.