In November 2021, a BofA Securities strategist provided eight reasons for ranking U.S. energy stocks the No. 1 most attractive sector in the S&P 500. The potential for geopolitical conflict, which sadly later occurred in the Ukraine, was only one driver of the expected price rally in oil.
In an update this week, the strategist, Savita Subramanian, noted that while the Russia/Ukraine conflict is likely already priced into crude, the other seven reasons for bullishness are still in play. For her, this strongly suggests oil prices will remain elevated for the foreseeable future.
In brief, the seven remaining reasons are: energy stocks offer inflation-protected yield; the sector is close to record low valuations relative to strong cash flow generation; actively managed funds are still 30 per cent underweight; capital discipline has been maintained; decarbonization plans are reducing ESG-related investor opposition; sector earnings are predicted to exceed consumer discretionary stocks; and funds that are underweight are significantly underperforming the benchmark.
The S&P 500 Energy Index’s year to date return of 29.6 per cent has outperformed the S&P 500 by almost 40 percentage points. Domestically, the S&P/TSX Energy index has climbed 22.1 per cent, easily outdistancing the primary benchmark’s 1.5 per cent appreciation.
The majority of fund managers that remain underweight in oil and gas stocks, for ESG reasons or any other, are experiencing career risk – underperforming their benchmarks by a wide enough margin that their jobs are increasingly threatened. The temptation to capitulate and allocate assets to the sector will be very strong in many cases and this would push related stock prices even higher.
Somewhat surprisingly, U.S. energy stocks remain attractively valued after the strong rally (comparable data is not available for Canadian companies, although many also trade in the U.S.). Based on historical averages, Ms. Subramanian estimates 62 per cent potential upside based on current price to operating cash flow multiples. A jump in energy stock prices to average price to book value ratios implies 48 per cent upside.
The most profitable investment time horizon for investment in oil and gas is difficult to gauge. Over time, renewable power will cut deeply into fossil fuel demand but it will be a number of years before these effects become financially tangible. An increase in nuclear power is almost guaranteed but facilities cannot be built overnight, and the related politics remain contentious and likely to cause construction delays at the very least.
There are many ways in which energy stocks have been pushed into the sin stock category because of environmental concerns, joining alcohol and tobacco. But here’s a fact investors may want to consider: tobacco stocks were the top performing market sector between 1900 and 2020, turning a US$1 investment into more than US$8-million.