Energy Retreat Could Spell Opportunity

The S&P 500 Energy Index is off 17.54% from its 52-week high. Not only is that enough for a dangerous flirtation with a bear market, but that decline is enough to potentially scare investors away from what’s been this year’s best-performing sector.

This is ideal time for advisors to remind clients that nothing moves up in a straight line and that’s particularly true of energy assets. With this sector, there are bound to be bumps along the way. On the other hand, energy remains a premier inflation fighter and its large, recovering dividends are hard to ignore, particularly with improving balance sheets across the group.

Put it altogether and the near-term view of the energy sector is arguably a good news/bad news proposition, but some experts believe this pullback is an opportunity to get involved.

Points in Favor of Energy

Indeed, with all the talk about environmental, social and governance (ESG) investing and sustainability, many clients are perplexed about the resurgence of fossil fuels stocks and funds. However, a logical, pragmatic energy transition should still feature fossil fuels to smooth dependability issues with renewables.

While it seems counterintuitive to novice investors and clients that aren’t well schooled in energy’s inner workings, the clean energy transition is actually a plus in some regards for the old guard energy sector. Adding to the allure of the latter is that it’s still attractively valued despite impressive showings last year and through the first half of 2022.

“While volatility may continue in the near term, we believe selloffs may provide more attractive entry points for investors, particularly those that remain underweight energy stocks,” according to First Trust research. “While we concede that a deep global recession could negatively impact demand for fossil fuels in the near term, we believe longer-term supply-demand dynamics, as well as geopolitical influences, will likely support relatively high prices for oil and natural gas, which may continue to fuel robust earnings for energy companies. Moreover, despite relatively strong performance since the Fall of 2020, energy stock valuations remain historically cheap.”

Yes, it’s to be expected that clients are asking about renewable energy and the threat it poses to oil and natural gas and while clean energy stocks are rallying with some help from Capitol Hill, obituaries for oil are being penned far too early.

“One key reason we expect oil demand to be resilient even with higher renewable energy production is because the two are not direct substitutes. Renewable energy is generally used in electricity production, an area that accounts for under 3% of global oil consumption3 . Approximately 60% of global oil consumption is for transportation, with the majority being used in passenger vehicles.,” adds First Trust.

Said another way, electric vehicles are bigger threats to oil than solar or wind.

Solid Fundamentals

Even when allotting for the rise of electric vehicles adversely affecting oil, there’s a lot of moving parts. For example, electric vehicle producers still need to get to price parity with internal combustion engine vehicles and they need to solve the riddles of infrastructure and mileage per charge. Additionally, there’s little attention to paid how EVs are charged at residences. Hint: It’s mostly by fossil fuels.

As for clients that don’t want to deal with the political haranguing – who can blame them? – and just focus on fundamentals, there’s good news in the energy patch.

“With earnings estimates improving and stock prices moving lower, valuations within the energy sector continue to look attractive. As of 7/31/2022, the S&P 500 Energy sector was trading at 7.8x one year forward earnings estimates, below the 18.2x of the S&P 500 Index. In our opinion, today’s relatively low valuations suggest that optimism is lacking, despite intriguing developments that may spur earnings growth for the sector,” concludes First Trust.

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