Posted inFSA Analysis

Will energy stocks continue their momentum in 2023?

The momentum in energy stocks of the past two years may have run its course.

The preference among asset allocators for energy stocks on the back of last year’s impressive gains may prove short-sighted, market observers told FSA, as it is uncertain whether they can continue their stellar run of the past two years.

In a year when every other sector in the S&P 500 lost money, energy stocks delivered an average return of 59% last year on the back of an already impressive 55% gain in 2021.

This came despite the pull-back in oil prices from their peak of $130 a barrel in March last year shortly after Russia invaded Ukraine. This was due to record shareholder distributions and the burgeoning ESG credentials of the six US and European majors – Exxon, Chevron, Shell, TotalEnergies, Conoco and BP – which has made them more favoured among investors again.

Anecdotally, several fund selectors said that they have been onboarding more commodity-related strategies in response to investor demand and several analysts have said that they expect that the strong performance of the oil majors to continue this year.

Supporters of this theory point to the fact that comparatively energy stocks remain cheap. The forward price-to-earnings ratio of the S&P 500 stands at 16.7x compared with 9.8x for energy stocks.

In addition, the oil majors remain flush with cash, which is likely to be put to work in the form of dividends and share buybacks, while their long-term trend of low capital spending has given investors confidence that supplies will remain limited and therefore prices elevated.

“Although it is hard to envisage the rally in European energy prices continuing at the rate previously, the Ukraine situation remains tense and it is unlikely to change in the short term.”

George Dent, Client Investment Manager, BNY Mellon

Finally, the Russia-Ukraine war has descended into a quagmire and other geopolitical tensions, notably between China and the US, may also weigh on oil prices.

“Although it is hard to envisage the rally in European energy prices continuing at the rate previously, the Ukraine situation remains tense and it is unlikely to change in the short term,” said George Dent, client investment manager at BNY Mellon.

“Furthermore, any escalation of geopolitical tensions will shock the market.”

However, there is a growing chorus of fund selectors, asset managers and analysts who think that energy stocks have rallied as much as they will do, particularly with recession looming. One often-cited study by Citigroup shows that energy has been the worst performing sector during previous downturns with earnings per share falling by 53% to 124%.

Ulrik Fugmann, co-head of the environmental strategies group at BNP Paribas Asset Management, described the increase in fund holdings in energy companies as a “classic mistake” and would be susceptible to a downturn in commodity prices.

“When oil prices are low, oil companies look expensive on most metrics due to lower revenues and profitability, whilst when oil prices are high, oil companies look cheap as revenue is high and profitability high,” he said.

Instead, Fugmann is one of several market observers who is predicting a better performance for clean energy stocks.

The broad Morningstar US Sustainability Index fell 18.9%, which was roughly comparable to the 19.4% decline in the S&P 500. Sustainable investing suffered generally last year due to its correlation to growth stocks, although this has proved a boon more recently as growth stocks have started to outperform again.

The sector also received a timely boost though from the Inflation Reduction Act in the US, which was passed last August and brings about $370bn in subsidies for clean energy investment, Fugmann noted.

Part of the Mark Allen Group.