Energy stocks are finally catching up to the rally in crude prices, a sign that investors are increasingly positive about the long-term prospects of oil companies.
Accelerating global growth has increased demand for commodities, drawing down oil inventories and helping push oil prices to three-year highs. Meanwhile, a rout in oil prices from more than $100 a barrel to under $30 in early 2016 led to extensive cost cutting by producers, meaning they can now make more money at lower prices, investors say.
Energy stocks are up about a fifth in the past six months, according to the MSCI World Energy Index. In the U.S., such stocks in the S&P 500 (.SPX) have returned 18.3% over that period, making them one of the index's best-performing sectors.
While oil and gas shares have broadly followed crude prices in those six months—West Texas Intermediate, the U.S. crude gauge, is up about 36%—it took awhile for them to catch up, a sign that some investors lacked conviction in the oil recovery.
Now, they are seeing the sector differently.
"It now appears, which it did not for a good portion of the last four or five months, that the supply-and-demand imbalance that was driving oil prices up is going to be sustainable for the rest of 2018," said Lisa Shalett, head of investment at Morgan Stanley Wealth Management.
Many analysts think that U.S. energy stocks will continue to outperform broader equity markets this year. To do that, "we don't think oil needs to move higher," said Ethan Bellamy, energy analyst at Baird. "Rather, oil just needs to avoid another correction."
The current recovery in oil prices started in the summer of 2017, helped by a deal by the Organization of the Petroleum Exporting Countries and other major suppliers to cut production to tackle a glut in supply.
Now demand is also increasing, and investors are focusing on a key bellwether that suggests it could at last be outstripping supply. Over the past month, long-term futures contracts have become cheaper than short-dated ones—a situation called backwardation.
For many years, storing crude was profitable because the price of oil delivered in the future was higher than the price of oil delivered right away, a sign of weak demand. Now, the premium is for delivering the commodity sooner.
According to the Energy Information Administration, U.S. crude stockpiles have fallen for the past 10 consecutive weeks and are at their lowest since early 2015.
An analysis by Morgan Stanley Wealth Management shows that the energy sector tends to outperform the broader S&P 500 index by about 6 percentage points in the year after the oil market shifts to backwardation.
"We are still pretty constructive on demand," said Neil Gregson, a fund manager at J.P. Morgan Asset Management.
Mr. Gregson has ample holdings in oil behemoths such as Royal Dutch Shell PLC (RDS/A) and Chevron Corp. (CVX), but is especially optimistic about the growth potential for smaller drilling firms, such as Pioneer Natural Resources Co. (PXD) and Parex Resources Inc. (PARXF).
What makes many investors bullish about the energy sector is companies' newfound focus on profits over volume. Before 2014, many producers were pumping ever more oil and gas even while incurring losses doing so, but over the past six months they have focused on short-term profitability, analysts say.
Companies such as Anadarko Petroleum Corp. (APC) have detailed plans to reduce 2018 spending on drilling and operating wells. Chevron plans to cut such investments by almost 10%. Their share prices are up 35% and 26%, respectively, over the past six months.
Indeed, while net margins in the S&P 500 energy sector are still much below where they were between 2011 and 2014, when WTI traded around $100, their profitability is getting close to levels then, even though they sell oil at much lower prices.
Free cash-flow margins, which measure how much cash a corporation generates for each dollar of sales after paying for investments, are now close to 4% in the sector. In 2013, they had dipped below 2%.
"It's a much better-run sector today," said Stephanie Butcher, a fund manager at Invesco Perpetual, who holds large allocations in energy stocks. "A few years ago, management teams were choosing volume over value; today it's all about cost control."
To be sure, energy companies still have their issues, such as the hefty piles of debt that were built up before 2014. Shares in the energy sector are also currently the most expensive in the S&P 500, trading at 24 times the earnings companies are expected to generate for investors over the next 12 months. That compares with 20 times for the tech sector and 18 times for the S&P 500 as a whole.
But oil itself is expected to stay onside for this sector. Analysts predict that crude will stay in the $60s range this year, relative stability that is good for energy equities.
"As long as oil prices don't collapse, equities should grind higher," said Jon Morrison, Calgary-based oil equity analyst with CIBC Capital Markets.
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