It has been a boom-and-bust year for oil stocks -- but the energy sector looks like it's getting ready to run again.
For much of 2022, oil stocks were the only ones going up as the S&P 500 slumped. Much of that had to do with the surging price of oil, which was already high before Russia - Ukraine war kicked the rally into overdrive. But crude prices peaked in June as recession concerns dominated, and oil stocks peaked with them, with the Energy Select Sector SPDR exchange-traded fund (ticker: XLE) tumbling 27% from June 8 through July 14.
Oil prices have continued to fall, some by 5.5% since mid-July. Yet the Energy Select Sector SPDR has risen 18%, outperforming the S&P 500's 13% gain by five percentage points over the same period. And for good reason. Oil companies are minting money, and as long as crude prices don't fall too much further, the rally should continue.
Everything starts with the price of oil, and risks abound. Macquarie Group strategist Vikas Dwivedi notes that a combination of lower consumer demand, continued access to Russian oil despite the war, and the possibility of more production out of Saudi Arabia and the U.S., among other factors, could cause oil to fall below $70 over the next few months.
But OPEC might be more constrained in production than expected, says Mark Haefele, chief investment officer at UBS Global Wealth Management, while Chinese demand could recover over the rest of the year as rate cuts by the People's Bank of China begin to boost the economy. At the same time, high coal and natural-gas prices could keep demand for oil strong. "We continue to see a tight oil market and retain our positive price outlook," he writes.
Either way, energy stocks should hold up OK. A big part of that is earnings. It's no coincidence that the sector's rally coincided with reporting season. Energy stock profits rose nearly 300% during the second quarter, according to Refinitiv, nearly 10 times faster than the next sector, industrials, which grew earnings at a 32% clip. Energy stocks have increased earnings by 400% from 2019, says DataTrek Research's Nick Colas. "Their earnings power is far better than prepandemic, and we believe that can continue," he writes.
They also remain dirt cheap. The Energy Select Sector SPDR trades at just 8.5 times 12-month forward earnings, well below the S&P 500's 18.2 times and below its own 10-year average of 16.4. In an environment where price/earnings ratios could remain under pressure, that kind of valuation looks particularly attractive, Colas says.
Energy stocks have one more thing going for them: The companies' intense focus on returning cash to shareholders. The Energy Select Sector ETF has a dividend yield of over 3%, higher than both the S&P 500's 1.4%, and competitive with a 3% 10-year Treasury yield. And oil companies appear committed to making hefty payouts, even at the expense of exploring for more crude.
Those payouts look particularly attractive in a volatile market, where dividends and buybacks can end up making up a large share of returns. 22V Research's Dennis DeBusschere screened for the 50 companies in the S&P 500 with the highest cash-return levels, and 12 energy companies, including Pioneer Natural Resources (PXD), Marathon Petroleum (MRO), ConocoPhillips (COP), and Exxon Mobil (XOM), made the list.
It's a crazy notion, but oil stocks might provide a dash of safety in a wild market.