At the beginning of the year, I recommended buying oil stocks, even while I observed it would take a hope and a prayer to get them moving higher. My prayers were answered: The energy sector has gained nearly 20% since then. The question now is whether that run can continue.
Almost certainly. The Energy Select Sector SPDR XLE -0.8309859154929577% Energy Select Sector SPDR ETF U.S.: NYSE Arca 70.41 -0.59 -0.8309859154929577% /Date(1471640400069-0500)/ Volume (Delayed 15m) : 10565565 AFTER HOURS 70.41 % Volume (Delayed 15m) : 480176 P/E Ratio N/A Market Cap N/A Dividend Yield 2.4793694077545805% Rev. per Employee N/A More quote details and news » ETF (ticker: XLE) has gained 19% this year, nearly triple the Standard & Poor’s 500’s 7% rise—putting the fund in the same lofty territory as those popular utilities and telecommunication companies. With such monumental gains, it’s easy to imagine the rally running out of juice, especially if the price of oil—the rise of which served as the catalyst for the rally—remains mired below $50 a barrel.
The energy sector, however, has been getting pummeled so hard for so long that this year’s gains might be the beginning of a multiyear run. With valuations starting to look reasonable, and higher oil prices a possibility, opportunity still exists for investors who missed the initial rally.
Much will depend on the price of crude. Investors got a scare earlier this month when oil tumbled 23% from its June 8 high of $51.23, to $39.51 on Aug. 2, as concerns about gasoline supply pushed prices into bear-market territory. As a result, the Energy Select Sector SPDR dropped 5.2%. Such bouts of volatility won’t go away as oil prices react to the headlines, whether about fundamentals such as inventories and production, or OPEC policy.
Still, there’s a good chance that oil moves higher. For starters, the massive oversupply that greeted the world at the beginning of 2016—some one million barrels a day—has largely been worked off, as producers cut back and demand for cheap oil has picked up, says Helima Croft, global head of commodity strategy at RBC Capital Markets.
THE GLUT OF OIL IN STORAGE, meanwhile, will be gradually reduced over the course of 2017, courtesy of political unrest in places such as Nigeria, Venezuela, and Libya. “We think oil grinds higher,” says Croft, who expects it to end this year at $58 a barrel and sees it averaging $64 a barrel in 2017.
She isn’t the only one expecting an oil rally. The commodity strategists at Bank of America Merrill Lynch expect the price of oil to rise to $54 by the end of 2016, and to $69 by next June. That was a big reason the investment bank upgraded the energy sector to Overweight last week. It wasn’t alone.
First, valuations are starting to look more attractive. Yes, oil stocks still trade at about 40 times forward earnings expectations, but that number is based on very depressed earnings, says Merrill Lynch strategist Dan Suzuki. Earnings estimates are starting to rise. In July, nearly twice as many oil companies saw Wall Street analysts revise their earnings estimates higher rather than lower, the highest ratio in at least five years—and those revisions should continue as oil stabilizes and moves higher. And on other metrics, energy stocks are clearly cheap. On book value, energy trades at a 38% discount to the S&P 500, near a 30-year low.
BUT PERHAPS THE BEST REASON to expect more gains from energy stocks is the extent to which they’ve been hurt by the recent selloff. The Energy SPDR plunged 28% over the past two years, even as the S&P 500 gained 10%. Because of that decline, energy now makes up just a hair less than 7% of the S&P 500, down from a peak of more than 13% in 2008. Suzuki notes that since 1990, when the energy sector’s weighting in the S&P 500 has fallen below 7% of the S&P 500, it has always gone on to outperform the benchmark over the next three years. “Relative to its underperformance, the recent outperformance is small,” Suzuki says.
Individual energy companies have rapidly adapted to lower oil prices, and the market is rewarding those that have made the biggest strides. Decisions to increase production are seen as a sign that debt levels have been brought down to sustainable levels, costs are under control, and a company is ready to grow again.
Guggenheim’s Subash Chandra points to Encana ECA -0.09852216748768473% Encana Corp. U.S.: NYSE USD10.14 -0.01 -0.09852216748768473% /Date(1471640483287-0500)/ Volume (Delayed 15m) : 11643164 AFTER HOURS USD10.11 -0.03 -0.2958579881656805% Volume (Delayed 15m) : 2739 P/E Ratio N/A Market Cap 11074197091.1674 Dividend Yield 0.591715976331361% Rev. per Employee 1488530 More quote details and news » (ECA), Southwestern Energy SWN -4.589707927677329% Southwestern Energy Co. U.S.: NYSE USD13.72 -0.66 -4.589707927677329% /Date(1471640548380-0500)/ Volume (Delayed 15m) : 10960465 AFTER HOURS USD13.72 % Volume (Delayed 15m) : 171976 P/E Ratio N/A Market Cap 6770216364.67712 Dividend Yield N/A Rev. per Employee 933000 More quote details and news » (SWN), and SM Energy SM -0.0545404963185165% SM Energy Co. U.S.: NYSE USD36.65 -0.02 -0.0545404963185165% /Date(1471640626107-0500)/ Volume (Delayed 15m) : 3203957 AFTER HOURS USD36.65 % Volume (Delayed 15m) : 105509 P/E Ratio N/A Market Cap 3183675563.99078 Dividend Yield 0.2728512960436562% Rev. per Employee 1490840 More quote details and news » (SM), each of which has gained more than 85% this year, as examples of exploration-and-production companies that have benefited from raising production targets.
Chandra recommends companies on the verge of doing the same thing. The company that’s closest is Continental Resources CLR 0.10273268954181221% Continental Resources Inc. U.S.: NYSE USD48.72 0.05 0.10273268954181221% /Date(1471640521196-0500)/ Volume (Delayed 15m) : 1571394 AFTER HOURS USD48.9 0.18 0.3694581280788177% Volume (Delayed 15m) : 40463 P/E Ratio N/A Market Cap 18248661668.1665 Dividend Yield N/A Rev. per Employee 1871930 More quote details and news » (CLR), which last week announced it had sold land in North Dakota and Montana for $220 million. Bigger yet riskier opportunities might be found in Anadarko Petroleum APC -1.9842688594923132% Anadarko Petroleum Corp. U.S.: NYSE USD54.83 -1.11 -1.9842688594923132% /Date(1471640492831-0500)/ Volume (Delayed 15m) : 3027601 AFTER HOURS USD54.83 % Volume (Delayed 15m) : 137847 P/E Ratio N/A Market Cap 27988358284.8334 Dividend Yield 0.3647638154295094% Rev. per Employee 1359830 More quote details and news » (APC), which could be finished with its debt reduction by the end of the year, or Whiting Petroleum WLL -4.285714285714286% Whiting Petroleum Corp. U.S.: NYSE USD8.04 -0.36 -4.285714285714286% /Date(1471640488221-0500)/ Volume (Delayed 15m) : 16477666 AFTER HOURS USD8.03 -0.01 -0.12437810945273632% Volume (Delayed 15m) : 75233 P/E Ratio N/A Market Cap 2214175701.16444 Dividend Yield N/A Rev. per Employee 1290700 More quote details and news » (WLL), which should be done by the middle of 2017.
“You’ve gone from dying to living, even thriving,” Chandra says. “As long as oil is roughly $50, we’re ready to go.”
Like Barron’s on Facebook
Follow Barron’s on Twitter