- Oil prices are currently down by more than 30% from their 52-week highs.
- Energy stocks remain cheap despite the major runup earlier in the year.
- Energy stock PE ratios suggest many companies are still significantly undervalued.
Oil prices climbed on Monday morning after OPEC+ resolved on Sunday to stay the course on oil production cuts ahead of the implementation of a $60 price cap on Russian-origin crude oil negotiated by the EU, the G7, and Australia. OPEC+ had earlier agreed to cut output by two million bpd, about two per cent of world demand, from November until the end of 2023.
Still, oil prices are down more than 30% from their 52-week highs while, curiously, the energy sector is within just four percent of its high. Indeed, over the past two months, the energy sector’s leading benchmark, the Energy Select Sector SPDR Fund (NYSE:XLE), has climbed 34% while average crude spot prices have declined 18%. This is a notable divergence because the correlation between the two over the past five years is 77% and 69% over the past decade.
According to Bespoke Investment Group via the Wall Street Journal, the current split marks the first time since 2006 that the oil and gas sector has traded within 3% of a 52-week high while the WTI price retreated more than 25% from its respective 52-week high. It’s also only the fifth such divergence since 1990.
David Rosenberg, founder of independent research firm Rosenberg Research & Associates Inc, has outlined 5 key reasons why energy stocks remain a buy despite oil prices failing to make any major gains over the past couple of months.
#1. Favorable Valuations
Energy stocks remain cheap despite the huge runup. Not only has the sector widely outperformed the market, but companies within this sector remain relatively cheap, undervalued, and come with above-average projected earnings growth.
Rosenberg has analyzed PE ratios by energy stocks by looking at historical data since 1990 and found that, on average, the sector ranks in just its 27th percentile historically. In contrast, the S&P 500 sits in its 71st percentile despite the deep selloff that happened earlier in the year.
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Some of the cheapest oil and gas stocks right now include Ovintiv (NYSE:OVV) with a PE ratio of 6.09; Civitas Resources (NYSE:CIVI) with a PE ratio of 4.87, Enerplus (NYSE:ERF) has PE ratio of 5.80, Occidental Petroleum Corporation (NYSE:OXY) has a PE ratio of 7.09 while Canadian Natural (NYSE:CNQ) has a PE ratio of 6.79.
#2. Robust Earnings
Strong earnings by energy companies are a big reason why investors are still flocking to oil stocks.
Third quarter earnings season is nearly over, but so far it’s shaping up to be better-than-feared. According to FactSet’s earnings insights, for Q3 2022, 94% of S&P 500 companies have reported Q3 2022 earnings, of which 69% have reported a positive EPS surprise and 71% have reported a positive revenue surprise.
The Energy sector has reported the highest earnings growth of all eleven sectors at 137.3% vs. 2.2% average by the S&P 500. At the sub-industry level, all five sub-industries in the sector reported a year-over-year increase in earnings: Oil & Gas Refining & Marketing (302%), Integrated Oil & Gas (138%), Oil & Gas Exploration & Production (107%), Oil & Gas Equipment & Services (91%), and Oil & Gas Storage & Transportation (21%). Energy is also the sector that has most companies beating Wall Street estimates at 81%. The positive revenue surprises reported by Marathon Petroleum (NYSE:MPC) ($47.2 billion vs. $35.8 billion), Exxon Mobil (NYSE:XOM) ($112.1 billion vs. $104.6 billion), Chevron (NYSE:CVX) ($66.6 billion vs. $57.4 billion), Valero Energy (NYSE:VLO) ($42.3 billion vs. $40.1billion), and Phillips 66 (NYSE:PSX) ($43.4 billion vs. $39.3 billion) were significant contributors to the increase in the revenue growth rate for the index since September 30.
Even better, the outlook for the energy sector remains bright. According to a recent Moody's (NYSE:MCO) research report, industry earnings will stabilize overall in 2023, though they will come in slightly below levels reached by recent peaks.
The analysts note that commodity prices have declined from very high levels earlier in 2022, but have predicted that prices are likely to remain cyclically strong through 2023. This, combined with modest growth in volumes, will support strong cash flow generation for oil and gas producers. Moody’s estimates that the U.S. energy sector’s EBITDA for 2022 will clock in at $$623B but fall to $585B in 2023.
The analysts say that low capex, rising uncertainty about the expansion of future supplies and high geopolitical risk premium will, however, continue to support cyclically high oil prices. Meanwhile, strong export demand for U.S. LNG will continue supporting high natural gas prices.
In other words, there simply aren’t better places for people investing in the U.S. stock market to park their money if they are looking for serious earnings growth. Further, the outlook for the sector remains bright.
Whereas oil and gas prices have declined from recent highs, they are still much higher than they have been over the past couple of years hence the ongoing enthusiasm in the energy markets. Indeed, the energy sector remains a huge Wall Street favorite, with the Zacks Oils and Energy sector being the top-ranked sector out of all 16 Zacks Ranked Sectors.
#3. Strong Payouts to Shareholders
Over the past two years, U.S. energy companies have changed their former playbook from using most of their cash flows for production growth to returning more cash to shareholders via dividends and buybacks.
Consequently, the combined dividend and buyback yield for the energy sector is now approaching 8%, which is high by historical standards. Rosenberg notes that similarly elevated levels occurred in 2020 and 2009, which preceded periods of strength. In comparison, the combined dividend and buyback yield for the S&P 500 is closer to five per cent, which makes for one of largest gaps in favor of the energy sector on record.
#4. Low Inventories
Despite sluggish demand, U.S. inventory levels are at their lowest level since mid-2000 despite the Biden administration trying to lower prices by flooding markets with 180 million barrels of crude from the SPR. Rosenberg notes that other potential catalysts that could result in additional upward pressure on prices include Russian oil price cap, a further escalation in the Russia/Ukraine war and China pivoting away from its Zero COVID-19 policy.
#5. Higher embedded “OPEC+ put”
Rosenberg makes a point that OPEC+ is now more comfortable with oil trading above $90 per barrel as opposed to the $60-$70 range they accepted in recent years. The energy expert says this is the case because the cartel is less concerned about losing market share to U.S. shale producers since the latter have prioritized payouts to shareholders instead of aggressive production growth.
The new stance by OPEC+ offer better visibility and predictability for oil prices while prices in the $90 per barrel range can sustain strong payouts via dividends and buybacks.