With many countries still unlocking from the binds of COVID, we see opportunities in the energy sector across world, US and Europe exposures. Concerns over new variants and any delays in vaccine delivery could provide buying opportunities in cyclical and value investments where earnings upgrades have made relative valuations look more attractive and many investors are still underweight.
Growth may be peaking, but the cycle has legs
The reflation trade has paused as investors consider that current inflation causes are transitory and growth may be peaking. Nevertheless, we believe it is too early to call time while some parts of the economy are still unlocking. Concerns over new variants and any delays in vaccine delivery will provide buying opportunities in cyclical and value investments where earnings upgrades have made relative valuations look more attractive and many investors are still underweight.
In line with this view, energy is one of our Sector Picks in the Q3 Sector & Equity Compass. We see opportunities in this sector across world, US and Europe exposures.
Not as unpopular
Figures in the Sector & Equity Compass show just how strong the relative performance of energy was in Q2, as well as Q1, and how it topped the charts in terms of flows into sector ETFs and into individual securities by institutional investors. State Street custody data also reveals the significant underweight position held by institutional investors.
In the first half of 2021, US energy produced net total returns of 42%* (with MSCI World Energy +30% and MSCI Europe Energy +17%) in response to the better outlook for oil and gas products and the ability to pass on higher commodity prices.1 Large earnings forecast upgrades left energy companies looking too cheap and there was a scramble for value exposure in equity markets. Progress in prices, earnings and P/E can be seen for the European sector in Figure 1 below.
Figure 1: European Energy - Price, Earnings, P/E
The significant price gains came despite strengthening opposition to fossil fuels. Governments, courts, shareholders and activists have all lined up against oil and gas producers, seeking to restrict their output and, ultimately, emissions. Even the IEA (International Energy Agency), an industry champion, turned last quarter and warned about the need to stop opening new oil fields and phase out oil-based power plants on the transition to Net Zero.
There is a long and expensive road ahead to energy transition, but this is now better understood by investors, reflected in valuations and, increasingly, as part of company management plans. We will undoubtedly hear more from the oil and gas companies as they address carbon emissions and this could win support of investors who have spurned the sector for environmental reasons.
Energy share prices lagging crude oil price curve
Last year, the OPEC+ alliance rescued the global oil industry from the ravages of the pandemic by agreeing large production cuts. However, that looks set to change with the big oil producers having just agreed an uplift in output from August. The new agreement removes a high level of uncertainty over crude oil supply and the modest increase does not appear to be impacting broker price forecasts for the commodity.
Brent crude oil futures are now trading at $71 per barrel, not far from this year’s high (with a low of $51). This price reflects the continuing oil supply crunch and low stockpiles (particularly in the US). Pertinent to the tight supply situation is the considerable increase in demand caused by the reopening of economies worldwide. Post-vaccination confidence has seen population mobility rise, raising demands from transportation, and recovery in industrial production and demand for raw materials.
High crude oil prices should continue to support energy sector share prices. Further drivers could come from a lift in dividend payments (cut during the pandemic to conserve cash) and possible share buybacks.
Stocks in the energy sector are highly correlated, responding in a similar fashion to market moves and making sector ETFs an effective investment vehicle. Given the scale of international trade and the importance of the oil price to sector fundamentals, returns in USD are similar, but there are differences at a regional level.
The US sector has high exposure to upstream exploration and production activities, which have greater operating leverage to crude oil prices. It also contains many large equipment and services companies that could benefit from later stage recovery after a return in capital expenditure.
Europe energy is a concentrated sector with only 12 stocks, led by former national champions that were well known for their dividend paying but were forced to cut last year. Income distribution should improve significantly this year. European exploration and production companies appear to be more pragmatic on the need to change operations to reduce carbon emissions and are showing faster transition.
How to access this theme
Investors looking to invest in the energy sector can do so with SPDR ETFs. To learn more about these funds, and to view full performance histories, please click on the links below.
* S&P Energy Select Sector Daily Capped 25/20 Index.
1 Past performance is not a reliable indicator of future performance. Index returns are unmanaged and do not reflect the deduction of any fees or expenses. Index returns reflect all items of income, gain and loss and the reinvestment of dividends and other income as applicable.
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