- After a rough first half of the year, the Energy sector started to show signs of market leadership in the summer as crude oil prices began to rise. The strength in crude is from significant ongoing commodity supply cuts and generally steady global demand. Additionally, we view the sharp recent depletion of US crude inventories as generally supportive for higher crude pricing near-term.
- Despite the strong recent move in Energy equities, sector valuations remain notably discounted to the broader market. The sector is also benefitting from substantial free cash generation and outsized capital return for many Energy-focused equities.
- Our work suggests that end markets with higher relative exposure to commodity spot pricing—in particular, equipment & services and exploration & production companies remain well-positioned in the current environment. Conversely, subsectors with comparatively lower exposure to commodity spot pricing, namely, midstream providers and the integrateds, are less likely to benefit from the move up in oil prices.
- With the potential for elevated volatility, we urge investors to remain diversified and limit individual equity exposure. Energy still accounts for less than 5% of the S&P 500 by total market capitalization.
Supply cuts fueling the current momentum in crude
We view the substantial ongoing supply cuts and steady overall global demand as positive drivers for the Energy sector. Recent strength in Brent/WTI crude reflects the bullish narrative around tighter global supply, which we believe could persist for some time. Energy has outperformed all respective sectors over the past three-month period.
Saudi Arabia recently extended its voluntary 1M barrels per day (bpd) crude oil production cut through year-end 2023, which is incremental to announced OPEC+ cuts already in effect. Perhaps more significant, Russia also extended its voluntary decision to pare crude exports by 300K bpd into 2024. Recall Russia continues to face numerous war sanctions (and has seen the departure of critical Energy infrastructure) following its invasion of Ukraine. Importantly, lower Russian output is noteworthy given continued production declines, which could suggest more permanent future capacity reductions over time. Early indications suggest strong compliance with the announced cuts from both countries, as seaborne crude and product exports from Russia recently fell to their lowest levels since September 2022.
The reductions in global supply have coincided with a sharp depletion in US crude inventories- now 34M barrels lower since mid-July levels (US Energy Information Administration or EIA). US demand has benefitted from resilient jet fuel demand and increased exports. Additionally, global demand has proven steady despite mixed industrial production throughout much of Europe and weakness throughout China’s property sector.
Valuations still attractive
Despite the strong recent move in Energy equities, sector valuations remain notably discounted to the broader market. Currently, the S&P 500 Energy Index trades at a discount of 6.7x versus the S&P 500 on forward EV/EBITDA, well ahead of the 20-year average variance (3.5x). Additionally, by total market capitalization, Energy still accounts for less than 5% of total S&P 500 holdings, still well below mid-2008 levels (15%).
The strong recent move in commodity pricing also potentially bodes well for positive H2’23 earnings revisions within the sector. Moreover, sequentially stronger earnings could provide added support for Energy valuations relative to current levels.
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