Energy: Another banner year ahead?

Key takeaways

• The energy sector is coming off a strong year, as tight supplies and rising demand fueled high energy prices in 2022.
• Those dynamics are likely to continue into 2023, given the long lead time it takes to ramp up new supply and refining capacity.
• The main risk for the sector for the next year is that a severe global recession or new COVID wave could substantially reduce demand, causing energy prices to drop.

Energy stocks had a banner year in 2022, driven by high oil and natural gas prices.

For 2023, barring a severe global recession, I believe that outperformance could continue, as many of the forces that propelled the stocks in 2022 could persist. Oil and gas demand should continue to grow in 2023 as economies continue to rebound from the pandemic. And supply is likely to remain constrained due to disruptions related to the Russian war in Ukraine and years of low investment in production.

Strong performance fueled by tight supply

Global oil and natural gas markets were already tight—with supply lagging demand—coming into 2022. Supply was constrained due to multiple years of low investment in production capacity. And energy demand had rebounded faster than expected from its pandemic lows, causing oil and gas inventories to decline and reach low levels by late 2021.

Those already tight market dynamics were exacerbated in 2022 by Russia's invasion of Ukraine, and the resulting supply disruptions. Russia's natural gas exports have declined dramatically since the invasion. Russian oil production has fallen modestly, but is expected to decline further as Europe implements tougher sanctions on Russian energy.

The past year also saw tight conditions for refined products (i.e., for consumable fuels like gasoline and diesel, as opposed to raw inputs like crude oil). Profit margins at refineries shot to record levels over the summer of 2022, when consumers were hitting the road for summer travel. That's partly because of disruptions of exports of refined products from Russia, but also due to a trend of refineries closing in recent years, as the world begins to shift toward renewables.

While these dynamics led to pain at the pump for consumers, they fueled a year of outstanding performance for energy-sector stocks.

Recognizing the sector's tight supply-and-demand profile, US oil and gas producers boosted production spending during 2022, up more than 50% from the lows in 2021. This spending led to more business for energy services firms—meaning the companies that provide the essential equipment and services to produce oil and gas, such as the rigs, crews, and technology needed to drill and complete a well.

Outlook remains tight—and constructive

Looking at 2023, supply-and-demand dynamics are likely to continue to be the main forces driving business results and stock performance across the various segments of the energy sector—including oil, gas, refining, and services.

Despite recessionary risks, demand for oil and gas is expected to grow in 2023 as economies continue to recover from the pandemic. Though investment in oil and gas production has been increasing, it will likely take at least several years for global supply to catch up with demand, supporting high oil and gas prices for some time.

Refining capacity also continues to look tight for 2023, given limited capacity and the long lead time it takes to bring new capacity online. This is likely to result in another strong year for the profitability of companies with refining operations. And energy services companies could experience strong earnings growth, as spending on exploration and production increases.

Of course, no sector is ever without risk. For the energy sector in 2023, the greatest risk may be that the demand side of the equation could weaken substantially. For example, if a severe global recession or new COVID wave were to significantly reduce economic activity or mobility, it could dampen energy prices and hurt stock performance.

Potential opportunities for 2023

I believe upstream energy producers (meaning those engaged in locating and extracting energy resources) could continue to benefit from high oil and gas prices. In particular, companies able to manage their businesses well in an inflationary environment could be better positioned. For example, Canada-based Cenovus () is an integrated energy company—meaning it handles not just exploration and production, but also refining.

International investment in drilling and production is set to increase more significantly in 2023 and beyond. For that reason, within the energy-services segment there could be potential upside for companies with exposure to international and offshore production. An example is SLB (), formerly known as Schlumberger, a leading global oil and gas services company.

In the refining segment, companies that have the ability to process a wide range of crude oil, such as Valero Energy (), could be well positioned to capitalize on wide refining margins and price differentials between high- and low-quality crude oil.

While the macroeconomic outlook is a bit of a wild card for the next year, I believe that demand from developing markets and from the post-pandemic recovery could continue to boost oil and natural gas demand for at least another 5 years. Meanwhile, I think oil and gas supply will remain constrained in the coming years, supporting high commodity prices. These dynamics bode well for the profitability for oil- and gas-related companies for 2023 and the next few years.