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Energy Sector: where there’s smoke (aka carbon emissions), there’s fire

  • Energy, while being up huge since late 2020, is still attractive

  • Cheap relative valuations, suddenly strong fundamentals, and still favorable sentiment make the space ripe for more gains over the next year

  • Investors wavering on ESG and chasing gains in fossil fuels is another tailwind

2022 has been the year of value so far. Cyclical value, to be specific. The energy sector has surged 18% in January while financials have fared fine despite a shaky reaction to earnings season. XLF is off less than 1% in January while the S&P 500 remains down 7%.

Energy Still Reasonably Priced

Energy ended 2020 strong and was the best sector in 2021 with its 53% advance. After years of painful underperformance for traditional energy, XLE is up 141% since November 2020 while the S&P 500 has returned 28%. Investors might be wondering how the valuation picture appears after such a massive rally. And considering the dip in the broader stock market, are relative valuations still attractive?

We assert the energy bull thesis remains alive and strong. Even with the huge runup over the last 15 months, oil & gas equities remain favorable on valuation, fundamentals, sentiment/technicals.

To start, the sector’s absolute valuation has actually ticked across the line into expensive territory, but relative valuations remain a full standard deviation to the cheap side. Also keep in mind the likelihood that valuation momentum often overshoots from one side to the other. Our featured chart illustrates that we are a far cry from the steal of a deal energy shares were at times in 2020, but they are still inexpensive versus the S&P 500. Backing out the last two years, relative valuations are near historic lows.

Featured Chart: Energy Sector No Longer Dirt Cheap, but Relative Value Remains

chart of US energy sector valuations shows energy cheap relative value

Fundamental Strength and (Bullish) Geopolitical Uncertainty

Making the valuation case more compelling is the current fundamental, macro and geopolitical environment. Last week, crude oil climbed to its highest price since September 2014 – above $90 on Brent. High oil prices coupled with the multi-year shock to energy supply growth (capex rates & rig counts running at record lows) are fuel to the fire for high profitability and free cash flow from the remaining publicly traded energy stocks. Recall how many E&P firms went belly-up or underwent forced sales during the oil bust.

Earnings Growth & Light Investor ETF Allocations

In fact, earnings have already significantly rebounded and should surpass the pre-pandemic EPS high later this year. The sector’s earnings contribution to the S&P 500’s EPS growth is on the mend – all while energy still only represents just 3.5% of the S&P 500. For perspective, the sector was more than 15% of SPX during the 2008 oil surge. Allocation-wise, US energy ETF AUM is a meager 1% of all US equity ETFs. There is room for much more upside.

Oil & Gas > Wind & Solar

Another persistent tailwind for the energy sector is the quick and massive interest shift away from renewables toward oil & gas. Poor ESG-stock performance is testing the mettle of investors who piled into the so-called green movement. Relative performance of renewables vs fossils is –55% since last January. We find that ESG Google Search Trends halved from the peak a year ago. At some point the green energy space will be attractive, too, but price momentum is with fossils for now.

Bottom Line: We reiterate our bullish stance on energy stocks that was initiated in August 2020. Relative valuations, strong fundamentals, and favorable sentiment/technicals make this leading S&P 500 sector still attractive.

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