Shares of energy companies are rallying as crude prices hover near $70 a barrel, a major reversal for a sector that just six weeks ago had been among the worst-performing groups in the stock market.
Energy stocks had fallen out of favor after many investors lost huge fortunes when oil prices began skidding in 2014 from above $100 a barrel to under $30. Even as prices showed signs of rebounding earlier this year, wary investors avoided the S&P 500 energy sector, which recorded its worst three-month stretch in three years in the first quarter.
But fears that bubbling Middle East tensions could disrupt oil production have pushed crude prices sharply higher in recent weeks. Stronger balance sheets, signs of improved profitability and a focus on boosting shareholder returns have also helped fuel the rebound in the energy sector.
Combined, this cast shares of many energy companies in a new light.
"When we use those [oil] prices now to look at equities, we think they are incredibly undervalued," said Stan Majcher, a portfolio manager with Hotchkis & Wiley, an asset manager that oversees about $31 billion.
The result: After closing out the first quarter as one of the worst-performing sectors in the S&P 500 (.SPX), energy shares have risen more than 10% in the past month to bring their gains for the year to 3.1%. The sector ranks as the index's third-best performer this year behind technology and consumer-discretionary shares.
Petroleum refiner Valero Energy Corp. (VLO), exploration and production firm Anadarko Petroleum Corp. (APC) and fellow E&P company Hess Corp. (HES) have all surged more than 20% this year, outpacing the S&P 500's slide of less than 0.1%.
Smaller energy equipment and services firms, whose shares tend to respond more to rising oil prices, have run up even more.
Many money managers continue to play coy with energy stocks. Fund allocations to shares of energy companies tend to be smaller than that of every other sector, with the exception of safety bets such as telecommunications, utilities and real estate, according to recent Bank of America Merrill Lynch data.
Investors' attitudes are changing, though, and not just because of oil's price. Profits rebounded at the world's biggest oil companies, with Exxon Mobil Corp. (XOM) and Chevron Corp. (CVX) last month posting their best first-quarter results in years.
In all, energy firms in the S&P 500 are on pace to report a 93% jump in earnings from a year earlier, more than doubling the earnings growth rate of technology and financial companies, according to FactSet.
Among the biggest winners: ConocoPhillips (COP), which said in April that its quarterly profit jumped 52%, thanks in part to a pickup in drilling activity. Shares of the oil giant have risen 23% this year.
That has led money managers such as Credit Suisse to take a more bullish stance on the sector. In March, the Swiss bank told clients they should consider boosting their allocations to energy stocks now that valuations are at more attractive levels.
Another factor that has helped the energy sector is healthier balance sheets. Companies have aggressively cut costs, curtailed spending and, in some cases, shut down wells in a bid to improve cash flow. Those efforts have paid off, as most of the energy companies in the S&P 500 are now generating more cash than they are spending, according to FactSet.
"In general, there's been apathy about investing in energy," said Bill Costello, a portfolio manager at Westwood Holdings Group. With companies appearing to be on stronger financial footing, that could change, he added.
Financial discipline is showing up in other ways. Big energy companies are moving carefully to avoid overspending on projects now that could prove too costly or unsustainable if oil prices move significantly lower. Companies are opting to return some of their extra cash to shareholders instead of plowing that money into capital-intensive projects.
Energy companies have authorized roughly $7 billion in share buybacks so far this year, more than twice the amount from the same period a year earlier, according to Goldman Sachs. And others, including Exxon Mobil and Chevron, are opting to raise their dividends.
Chevron Chief Financial Officer Patricia Yarrington told analysts last month that dividend growth is the company's "No. 1" priority, followed by investing in the business and managing surplus cash.
Still, many investors are concerned that energy's recent gains could be fleeting.
In the U.S., oil production continues to grow. By some estimates, U.S. production is expected to overtake Russia in five years, and some worry the growing output from American shale producers could depress energy prices.
A strengthening U.S. dollar has also weighed on oil and other commodities prices, which are priced in the U.S. currency and become more expensive to foreign buyers when the dollar rises. The WSJ Dollar Index, which measures the dollar against a basket of 16 other currencies, on Friday posted its biggest three-week percentage gain since the period following the U.S. presidential election.
"The oil rally might last longer, but I'm skeptical about whether oil prices stay where they are," said Kate Warne, an investment strategist at Edward Jones.
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