The energy sector has been having a good autumn. After falling more than 16% through August, the S&P 500® Energy Index (total return) finally started marching higher, rising more than 10% through the middle of October.1
The sector is still down for the year—in fact, energy is the worst performing of the 11 sectors in the S&P 500—but that combination of gains and energy’s turn as market laggard may have some investors wondering if there’s an opportunity to be had. Could the recent in turn in energy’s fortunes herald the start of a rally? And if so, should investors jump on board?
“In our view, the short answer is: no,” Brad Sorensen, managing director of market and sector analysis for the Schwab Center for Financial Research. “The energy sector can be volatile and speculative and we see some signs that the current rally may not be sustainable.”
Here, we’ll take a closer look at why.
What’s fueling energy’s rally? As you might expect for a sector composed of companies engaged in the exploration, drilling, refining and marketing, storage and transportation of oil and natural gas (and coal), changes in oil prices are an important driver.
The price of benchmark West Texas Intermediate crude started the year around $53, but then tumbled through the spring to bottom out around $42 in June. WTI crude has since ground its way back above $51.2
A lot of other factors have also come into play. Hurricane Harvey’s arrival in Texas in late August took a lot of the country’s refining infrastructure offline, which temporarily restricted supply.
And because oil is a globally traded commodity, factors overseas have also come into play. The Organization of Petroleum Exporting Countries (OPEC) along with some other major oil producers have turned to production cuts in the hope of driving oil prices higher after a multi-year supply glut. There is now talk that the group may extend the cuts deep into 2018, though nothing is set in stone.
Finally, investor sentiment appears to have turned more favorable. Data from oilfield services company Baker Hughes have shown that the U.S. rig count had leveled off after months of growth, which may have contributed to the perception that producers have become more disciplined about how much supply they send to market.3
“Also, some investors appear to have decided that energy had been oversold,” says Brad. “We saw a rotation in the sector world as some money came out of the best performing sector for the year—technology—and went into the worst performing sector of the year—energy—based on the performance of both sectors through August and part of September.”
Whether these factors are durable enough to drive energy stocks higher is another question.
What comes next
One source of uncertainty is whether supply discipline will hold. Should producers in the U.S.—whose ability to quickly ramp up production when prices rise has improved markedly thanks to technological improvements such as hydraulic fracturing, or fracking—and overseas seize on rising prices as an opportunity to open the spigots again, prices aren’t likely hold steady for long.
“We would urge investors not to load up and overweight the energy sector despite the recent rally,” Brad says. “We remain skeptical that oil producers can maintain long-term discipline.”
In fact, U.S. production has been rising despite the setback from the hurricane, and the Energy Information Agency actually predicts output will grow from an average 9.2 million barrels a day in 2017 to 9.9 million b/d in 2018—which would be an all-time record.4
And Brad is skeptical the OPEC agreement will be able to deliver as planned, as some countries aren’t totally satisfied with the way the oil cartel has shared the burden of cuts among members and Libya looks set to ramp up output after bringing a pipeline back online after repairs.
There’s also the bigger long-term trend of major oil users trying to limit their use of the fuel.
“France and Britain are reportedly looking to ban new gas and diesel cars over the next few decades, and China—the world’s largest auto market—has said it may do the same at some point,” Brad says. “Some car makers are also weighing all-electric futures.”
“I’m a little skeptical all this will happen as quickly as some expect, but there’s no denying the momentum around the world to move energy production away from oil.”
He adds that even as the world uses less of the oil industry’s wares, the big oil companies will surely adapt and end up being leaders in non-oil energy sources over time.
“We suggest investors keep a market weighting toward the sector, and enjoy the recent rally that has pulled the group back from the depths,” he says.
Again, the energy sector is just one of the 11 sectors in the S&P 500 Index, and we believe it’s important to have some exposure to all of them. Investors should aim to keep their exposures to the different sectors within a reasonable range—say, a few percentage points—of the market weighting. For energy, that would be about 6%.
1S&P data as 10/20/2017.
2Bloomberg data as of 10/20/2017.
3Baker Hughes data as of 10/20/2017.
4EIA data as of 10/11/2017.