Energy stocks finally caught fire in an increasingly uncomfortable context for investors.
For most of the past 12 months, the energy sector has been starved, as it was among the few sectors to lose ground in 2023. But since the beginning of March, the group is up 12, 5% en route to a 15% year-to-date gain, which is second best among the 11 S&P 500 sectors.
The sector’s rise is best explained by the recent rise in oil prices, which happens to be linked to the most serious risk in global markets: the growing conflict in the Middle East.
Oil has taken off on fears of supply disruptions caused by rising tensions in the region, starting with the Hamas terrorist attack on Israel on October 7 and the country’s subsequent retaliation. Last weekend, Iran fired more than 300 missiles at Israel after an Israeli attack on Iranian military officials at a diplomatic facility in Syria. Israel has largely succeeded in neutralizing this threat.
Brent crude oil prices have risen 18% since the start of the year to $90 a barrel, and some experts expect them to hit $100 in the coming months. In turn, investors shifted their money to oil companies.
However, supply issues cannot fully explain oil’s latest rise. Fuel demand is robust since the economy has been better than expected, Goldman Sachs strategists noted recently. Strong consumer spending supported oil prices, which then led to high inflation.
In a mid-April note, David Kostin, chief U.S. equity strategist at Goldman Sachs, wrote that oil prices were unlikely to rise much further from now on, barring significant economic deterioration or conflict in the Middle East. He added that Brent prices are expected to remain below $100 per barrel.
Energy stocks have hedging power and are powered by powerful catalysts
Rising oil prices are a headache for most businesses, Kostin noted, because rising fuel prices fuel inflation and put pressure on profit margins and consumer spending. Still, he added that the impact on S&P 500 earnings was broadly neutral, a relief in a crucial first-quarter earnings season.
Energy stocks are now a smart bet because they can help investors hedge against the risks that rising oil prices and intensifying geopolitical conflicts pose to the rest of their portfolios, Kostin wrote.
“Sectors exposed to commodities currently play a useful role in investors’ portfolios, particularly as a hedge against geopolitical and inflation risks,” Kostin wrote. “Commodities generally perform well during historical episodes of elevated geopolitical risk and periods of rising inflation.”
Mutual fund managers got that memo, as Kostin pointed out that these active managers are overweight energy as well as the materials sector, which is also very rich in commodities. However, hedge fund managers are underweighting these two sectors to a level not seen in a decade.
In addition to offering short-term downside protection, energy stocks appear to be an especially sound long-term investment since they are historically cheap, Kostin wrote.
In fact, the energy sector’s forward price-to-earnings (P/E) ratio of 12.3x is more than 34% below the S&P 500’s 18.8x mark, which the head of the strategy, is the largest relative valuation at the moment – and one of the highest. the biggest reductions in the last three decades. At the same time, Goldman Sachs found that energy has the highest free cash flow yield among sectors at 7%.
“While not a good indicator of short-term returns, the valuation discount creates an attractive entry point for long-term investors and should support capital return programs,” Kostin wrote.
Another compelling selling point for energy stocks is that there will be strong demand for oil in the long term, Kostin wrote. Emerging markets will need more fuel as they develop, and rapidly evolving technologies like artificial intelligence are very energy intensive.
“The long-term outlook for the energy sector remains attractive due to the combination of a steep valuation discount and favorable structural factors,” Kostin wrote. “Our commodity strategists expect long-term energy demand to remain strong, in part due to increased global energy demand driven by structural increases in transportation needs in emerging markets and AI.”
3 main energy stocks should perform well
Even if oil prices don’t skyrocket, Goldman Sachs analysts think energy stocks can stay hot — particularly three oil and gas companies that Kostin highlighted in his note: the refining giant Marathon Oil (MPC), oil services company Schlumberger (SLB), and exploration and production company ConocoPhillips (COP).
All three stocks will benefit from resilient long-term energy demand, Kostin wrote. They are also cheaper than the market, with earnings multiples ranging from around 8.8x to 17.7x.
Of the three, Marathon is by far the one that ran the furthest. Its 39.5% year-to-date gain is well ahead of ConocoPhillips’ 12.2% return, not to mention Schlumberger’s 0.7% loss. Each company has declined recently alongside the slight decline in oil prices and would benefit from a renewed recovery.