Energy stocks are enjoying their best market performance in years. They are also enjoying the best performance on the S&P 500 this year—at least so far. After years of poor earnings, poor market returns, and investors pulling out of oil and gas stocks, conventional energy stocks have come back with a bang.
Oil rallied above $100 a barrel after Russia invaded Ukraine. Still, public U.S. shale firms have refrained from returning to their old spending ways of sinking all their cash flow (plus a lot of borrowed money) into drilling so much oil that it would tank oil prices. The tight oil, gas, and fuel markets have also supported higher oil and gas prices. Oil and gas producers have also seen record cash flows and earnings. The scarcity in the global energy markets, chronic underinvestment in supply over the past few years, and the significant changes in global crude trade flows following the increasingly tighter sanctions against Russia have all joined forces to support oil and gas prices and stocks.
Fear Of Recession
But as the Fed moved aggressively and rolled out a plan to hike interest rates to tame rampant inflation—the highest in more than 40 years—Wall Street started fretting about the rising odds of a recession, which would depress oil demand going forward.
Investors in energy are now at a crossroads. The rally is too good to pass up, but traders fear there will be an end to these good times brought about by high gasoline prices that could soon start to destroy demand, and record-high diesel prices that could hit the economy hard? Others question the ability of the Fed to manage the proverbial “soft landing” of the U.S. economy while raising the key interest rate.
The odds of a recession have risen, but such an outcome is not the base-case scenario of many analysts and investment banks, who say that a recession is not inevitable.
A recession and a significant slowdown in global oil demand growth are the key downside risks for energy stocks. The ESG trend that has had investors shun traditional energy stocks could also impact investor sentiment.
Energy Is Top-Performing S&P 500 Sector
Yet, those investors who have stuck with energy stocks have been rewarded with handsome returns over the past year. As oil demand started to recover in 2021, energy stocks began to rise from the lows in 2020. With oil soaring to above $100 per barrel, the energy sector has been on a tear this year. Year to date to May 31, the energy sector in the S&P 500 had jumped by 55.7%, compared to a 13.3% decline of the index. Energy and utilities were actually the only two sectors with gains between January and May.
The energy sector was also the largest contributor to earnings growth for the S&P 500 for the first quarter of 2022, Factset data showed in May. Of all eleven sectors, the energy sector reported the highest annual earnings growth at 268.2%, thanks to oil prices that averaged 63% above the average price for oil in Q1 2021.
Related: OPEC Considers Extra Large Hike In Oil Production To Compensate For Russia
Out of the top ten best-performing stocks in the S&P 500 year to date, nine are energy companies, including Occidental, Marathon Oil, Coterra Energy, Valero, Halliburton, APA, Devon Energy, Hess, and Marathon Petroleum. Occidental has surged 139.1%, with much of the gain made in the past two months after Warren Buffett’s Berkshire Hathaway reported it had built a large stake of over 15% in the company.
“I decided that it was a good place to put Berkshire’s money,” Buffett said at Berkshire Hathaway’s annual meeting in April.
“She [Oxy CEO Vicki Hollub] says she doesn’t know the price of oil next year. Nobody does. But we decided it made sense,” Buffett added.
Do Energy Stocks Have Room To Climb Higher?
It’s been a pretty good year for energy shares.
Yet, with mounting macroeconomic headwinds, investors are now trying to predict how long the energy stocks party will last before a recession or a severe downturn in oil demand growth crashes it.
In the bullish camp, U.S. shale’s investment discipline helps support stocks as investors are pleased with the consistent restraint, which helps energy firms to earn record cash flows and boost dividends.
“In prior cycles ... companies would be spending like drunken sailors to put new rigs in the ground and find oil,” Walter Todd, chief investment officer at Greenwood Capital, which owns oil stocks including Chevron and EOG Resources, told Reuters.
This is no longer the case with the U.S. shale patch.
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Discipline has played a role in rallying stocks, but the highest oil prices since 2014 and multi-year low fuel inventories amid rising demand have been bigger contributors to the red-hot oil stock rally.
“This is the first time that energy companies have had a reason to smile since roughly 2014,” Stewart Glickman, energy analyst at CFRA Research, told Marketplace last week.
On the bearish side, an economic slowdown or a recession could stop the rally in its tracks if global oil demand suffers. But a recession is not inevitable, says Goldman Sachs, for example.
“We believe fears of declining economic activity this year will prove overblown unless new negative shocks materialize,” Goldman Sachs economists wrote in a report on May 30.
“We continue to forecast slower but not recessionary growth, with a trade-related rebound to +2.8% in Q2 followed by +1.6% average growth over the following four quarters,” Goldman Sachs said.
By Tsvetana Paraskova for Oilprice.com
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Long-term supporting bullish factors are a chronic global underinvestment in oil and gas production capacity, a shrinking global production capacity including OPEC+’s and a tightening market.
For these reasons oil and also gas prices are headed upwards and will remain there for the foreseeable future. And while anti-inflation measures along with rising oil and gas prices will lead to a harsh recession, the demand for oil for instance will remain intact. This will be a very unique situation for the oil and energy market. The reason is that in a tight market, demand destruction even in a recession will be extremely limited if non-existent. Any meaningful destruction could push the global economy towards collapse. So we will end up with oil demand intact, rising oil prices and a harsh recession, a contradictory but a unique cocktail.
And because of rising prices, the global oil and gas industry won’t be short of investors who will ignore the ESG trend altogether.
Dr Mamdouh G Salameh
International Oil Economist
Visiting Professor of Energy Economics at ESCP Europe Business School, London