After years of underperformance, energy stocks have emerged as market leaders in 2021.
The move has been a welcome relief for long-suffering shareholders of stocks like Schlumberger (SLB) , Occidental Petroleum (OXY) , and Pioneer Natural Resources (PXD) , which were battered by the Covid-19-driven dip in demand for oil and gas.
Occidental is perhaps one of the starkest turns of fortune, as its ill-timed Anadarko acquisition and subsequent macroeconomic pressures caused by Covid led to its severe laggard position prior to 2021. Over the past year, the stock has notched an over 100% gain, more than quadrupling the return of the S&P 500.
For a broader look at the recent move, the SPDR S&P Oil & Gas Exploration & Production ETF (XOP) has roared to an over 80% gain since the start of the year, while its cousin, the Energy Select Sector SPDR Fund (XLE) is up nearly 50%. For natural gas, the trend is even more striking.
Yet, whenever a sector soars to such heights, one must wonder how much steam a rally has left.
Roots of the Current Rally
In many ways, the present push upward for energy stocks is a product of their very unpopularity.
In recent years, ESG investing has become one of the greatest trends in investing. Inherent in this shift is an eschewance of many energy stocks that predicate their business on fossil fuels. As such, many institutional investors have worked to drop traditional energy names from portfolios and instead pivot to clean-energy alternatives.
As a result, Sean Fieler, President and Chief Investment Officer of Equinox Partners, opined that the current crisis and eye-popping prices at the pump are self-inflicted.
"Oil is in a structural, not cyclical, bull market. Western production may never recover from years of massive underinvestment." he told Real Money. "The developed world's preference for energy alternatives is driving underinvestment in hydrocarbons production and forcing energy prices higher."
At present, investors are still playing catch-up in the sector, eagerly jumping back into a sector they so hated in years gone by. In order to contend with this catch-up trend, Fieler suggested exploration and production companies are the most promising targets for investors. Even amidst the current rally, he argued that valuations remain appealing.
Meanwhile, based upon rapid recovery in demand from the depths of Covid-19's demand curtailment, Goldman Sachs analyst Neil Mehtra likewise remains optimistic.
"While we have long held a bullish oil view, the current global oil supply-demand deficit is larger than we expected, with the recovery in global demand from the Delta impact even faster than our above consensus forecast and with global supply remaining short of our consensus forecasts," he wrote in a recent report. "Meanwhile, winter demand remains skewed to the upside with a global natural gas shortage continuing to bite."
He recommended ConocoPhillips (COP) and Exxon Mobil (XOM) as his top picks as these trends continue to play out.
Geopolitical Jolt
Inherent in the issues noted above and observed more broadly in the energy industry are political problems.
Of course, top of mind for U.S. investors is the Biden administration's long-stated goal of cutting fossil fuel reliance.
Only a week after taking the oath of office, the President signed an executive order directing the relevant agencies to "ensure that, to the extent consistent with applicable law, Federal funding is not directly subsidizing fossil fuels." It added that all fossil fuel subsidies should be eliminated from the budget from 2022 onward.
Instead of reneging on these promises, the administration has instead moved to make overtures toward OPEC, supplicating the cartel to increase exports. As of yet, the request has fallen on deaf ears.
However, the crisis moves well beyond OPEC and the U.S. alone.
For example, recent droughts in Brazil have curtailed hydropower production and sparked demand for gas. Meanwhile, China has not slowed whatsoever in its energy demand. In fact, the East Asian nation has even slated plans to build more coal-fire plants in order to deal with its energy deficit, backing away from previous commitments on climate issues.
For Europe, progress against fossil fuels has left them in a lurch much like that of the United States. That is not to mention the serious issues presented by the completion of Nord Stream 2, a pipeline that leaves Europe increasingly dependent on Russian liquefied natural gas (LNG).
While leaders across the EU bloc argue that the high prices are transient, the current crisis is likely to last at least through the duration of the winter.
"Market expectations indicate that this is a temporary situation, but gas prices will remain high throughout the winter and should gradually decrease from Spring next year based on current demand forecast," EU Commissioner for Energy Kadri Simson said in recent official remarks. "The evolution of the winter season is a key variable to watch closely. This price shock cannot be underestimated."
Clearly from her remarks, there is serious concern that prices could remain elevated for a protracted period of time. Nonetheless, she argued for increased focus on the European Green Deal as a long-term solution. In the short-term, this could spell only more elevated energy prices across Europe.
Overall, as these political and structural dramas gradually play out, there appears ample time left to play the rally in energy even if you might have missed the initial surge.
"Over the very long-run we continue to forecast lower energy prices, but as Western firms step back from new large oil and gas projects, we believe the power of OPEC will rise over the next decade as their share of global output increases," Eric Leve, CIO of San Francisco Bay Area-based asset manager Bailard Inc. told Real Money. "We should only expect secular weakness when we are much farther down the road of transitioning away from fossil fuels."
