There has been a lot of commentary of late about the disconnect between oil prices and energy stocks - and for good reason. West Texas Intermediate (WTI) is now down 34% from its 52-week high whereas the energy sector in the U.S. is within 4% of its high.
This is a notable divergence because, over the last five years, the correlation between the two is 77% and over the last 10 years it is 69%. In other words, energy stocks (unsurprisingly) tend to track the direction of oil - both on the upside and the downside - due to the implications of movements in the commodity price for companies’ bottom lines.
With this in mind, we acknowledge there is the potential for weakness in energy shares in the near-term if oil prices remain under pressure - especially if we see WTI hold below US$80 per barrel.
But, we would use the selloff as a buying opportunity, because we believe the longer-term picture remains bullish. We see at least five key catalysts for the sector going forward which, to varying degrees, can help explain why the share prices of energy companies have held in well.
Favorable Valuations
Despite the recent run-up in energy stocks, they remain cheap in isolation, but especially relative to the S&P 500. We looked at a number of valuation metrics — such as EV/EBITDA, price-to-free cash flow, and the forward P/E ratio — since 1990 and took their percentile rank. The S&P 500 energy sector, on average, ranks in just its 27th percentile historically.
Conversely, the S&P 500 — despite the valuation adjustment that has occurred this year in response to higher interest rates — sits in its 71st percentile.
As a result, we would classify the energy sector as trading below-average from a valuations perspective whereas the broader market still looks too richly priced for our liking (especially given elevated recession risks). With the Fed continuing to remove liquidity, we see the greatest downside in high multiple segments of the market (due to further multiple compression) whereas cheaper areas (like energy names) are likely to fare better.
Positive Earnings Revisions
A combination of elevated oil prices (even with the recent decline) and better capital discipline has resulted in positive earnings revisions for the energy sector — in stark contrast to the broader market. Indeed, since the beginning of the year, 2023 earnings estimates for the energy sector have increased by a whopping +91.1%. For reference, the only other sector to see a positive trend is utilities (+2.0%) and the S&P 500 as a whole has been marked down by 2.7%.
What this has meant is that, even with the increase in the share prices of energy names, the boost to earnings estimates has been even larger. From our standpoint, this indicates that the rally in energy stocks has been entirely supported by improved fundamentals (as opposed to “lower quality” rallies that are driven by speculation).
Strong Payouts to Shareholders
Energy companies have made returning cash to shareholders - via dividends and buybacks - a primary focus, which investors are increasingly rewarding (especially in the context of a highly uncertain macro backdrop). In fact, the combined dividend and buyback yield for the energy sector is nearing 8%, one of the more attractive levels historically. Note that similarly elevated levels occurred in 2020 and 2009, which preceded periods of strength. By way of comparison, the combined dividend and buyback yield for the S&P 500 is closer to 5%. This is one of largest gaps in favour of the energy sector on record.
Low Inventories Despite Weak Demand
Despite sluggish demand, U.S. inventory levels (when accounting for the drawdown in the Strategic Petroleum Reserve (SPR) are at their lowest level since mid-2000. The SPR release - the largest ever - has helped put downward pressure on prices, but it also will need to be refilled in the future. In our view, this will help ensure a higher floor for oil prices going forward - even in spite of growing recession risks - since it will provide incremental demand against a backdrop of challenged supply. Not just that, but there are other potential catalysts that could result in additional upward pressure on prices — notably, the Russian oil price cap (it is unclear how Moscow will ultimately respond), a further escalation in the Russia/Ukraine war, and China pivoting away from its “Zero COVID-19″ policy. Equities are long duration assets and so we believe are appropriately discounting a prolonged period of elevated prices, even if oil is to remain weak in the near-term. Further to this point, we would note that the near-term futures contract has been much weaker than the 12-month out contract of late.
Higher Embedded “OPEC+ Put”
Speaking of a higher floor for prices, it is increasingly clear that OPEC+ is more comfortable with oil trading above $90 per barrel, a shift from recent years where they seemed content with prices in a $60-70 per barrel range. This seems to mostly be due to the fact that they are less concerned with losing market share to U.S. shale producers, which have been growing production more slowly as they have prioritized payouts to shareholders over drilling new wells. We believe this is yet another reason investors feel more comfortable holding energy names - since there is a level of visibility on prices that was sorely missing previously. Prices around $90 per barrel would ensure that energy stocks are able to sustain strong payouts via dividends and buybacks.
Bottom Line
There is little doubt that the recent weakness in oil prices, if it is sustained, will pressure the energy sector (especially if WTI holds below $80 per barrel). However, if a sell-off were to materialize, we would use it as a buying opportunity. Whereas the broader market remains expensive, energy is cheap by historical standards.
Furthermore, it has the added benefit of having positive earnings revisions and a very attractive combined dividend and buyback yield - characteristics that will help limit the extent of any selling pressure.
Finally, with low inventory levels - even in spite of weak demand - and clear signs that OPEC+ prefers a higher level for oil than in the past, we believe prices will remain well supported going forward (even with the potential for further near-term weakness). This dynamic will help ensure strong payouts from energy companies to shareholders, and provide a level of visibility that has been missing in recent years.
David Rosenberg is founder of Rosenberg Research, and author of the daily economic report, Breakfast with Dave. Brendan Livingstone is senior markets strategist with the firm.
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