Tag Archive: oil

Energy sector has rallied, but optimism is already high on crude oil

The recent returns of the Energy sector have been dramatic: in just two weeks from its latest trough on November 6th (just before the Pfizer vaccine news hit), the S&P 500 Energy sector rose 37%, the biggest return of any of the major sectors by a wide margin. The overall S&P 500 index, meanwhile, returned only 3.6% in that period. Most recently, the gains in Energy have cooled somewhat, but the sector (as of Dec. 2nd) is still up 30% from its November 6th level, well ahead of all other S&P 500 sector returns over the period.

The magnitude of the outperformance by Energy over such a short period is by far the biggest such move since the S&P sector return data begins in 1989.

This extraordinary move needs to be considered in context however.

It follows a sustained period of massive underperformance by the Energy sector. Over the 12 months through November 6th, the Energy sector had a -51% return, while the overall S&P 500 returned +14%. And in fact, the Energy sector has been underperforming the broader market fairly steadily since December 2016.

So one could certainly argue that Energy stocks were heavily out of favor and due for a rebound, and the recent vaccine news, with its hopes for a return to more normal levels of travel (and thus fuel use), has provided the spark for that rebound.

But because of the math of compounded returns, the huge recent outperformance only makes up a fraction of the cumulative underperformance since the start of the year, as reflected in the top section of the chart below.

Energy Sector and Crude Oil

What about the price of crude oil that so heavily influences Energy stock prices? Interestingly, crude prices have risen recently but less dramatically than the Energy sector stocks have. The average price of crude reflected in the futures markets over the next 12 months (which avoids quirks related to any specific futures contract) is at the high end of the range it has been in since early summer, around $45/bbl but still well below levels seen at the start of the year (middle section of chart). Oil’s recent movements have also been related to the OPEC+ meeting going on now that will influence how much new supply will be put on the market next year, following sharp output cutbacks this year.

Energy stocks continued underperforming over the summer and fall even as crude prices were range-bound, so the recent outperformance of Energy stocks looks more like stock prices catching up with the level of oil prices (after lagging oil’s movements earlier) rather than a response to a new dramatic rise in oil.

Can Energy stocks keep going? While short-term momentum can of course persist, the recent move has been extreme and thus has pushed Energy stocks closer to overbought conditions on a near-term basis. The bigger question is whether crude oil prices will move materially higher and thus help drive another leg higher for Energy stocks.

The near-term outlook for crude does not appear especially favorable for a couple of reasons. First, the current trends in COVID-19 in the US and Europe have led to more concern about travel (and therefore fuel use), not less, at least for now. The vaccines that have been announced will no doubt help, but will not be widely distributed for several months. If OPEC increases production, as they are discussing, prices may not gain much even with better demand.

The other concern is that sentiment toward crude oil is already quite optimistic, according to the surveys of market strategists published weekly by Consensus Inc. The latest readings show 62% of strategists are bullish on crude oil (bottom section of chart), matching the highest readings in the last several years (and far from the historically low readings around 20% in March/April). It is somewhat surprising to see such elevated bullishness given the price action in crude oil – normally sentiment tracks the price trend in the underlying market more closely. This implies that the majority of traders are already positioned for the potential good news from a return to more normal crude demand next year. The risk is therefore the contrarian concern that if most people are already positioned for higher crude prices, the opposite becomes more likely (absent an external shock).

Once Energy stocks have finished catching up with the current level of crude prices, and the heavy pessimism the stocks have faced this year has fully eased, further gains may be harder to come by. High optimism towards crude oil, combined with the potential for increased oil supply if demand does improve, suggests that the longer-term trend of Energy underperformance will be difficult to decisively break on an intermediate-term basis.

Big divergences in commodity space still favor Materials over Energy

One of the themes in our sector research for clients recently has been to focus on relative preferences within broader style or macro categories, rather than making big macro bets on Growth versus Value or Cyclical versus Defensive areas. We find that in a more range-bound market with conflicting macro trends, a more granular view is often more effective.

One stance we have held for some time has been within the Value-oriented commodity space. While in many cases historically the Energy and Materials sectors have moved together, this year has seen a dramatic divergence between the two commodity-related sectors. We have favored Materials over Energy this year, and still do, and below are some of the drivers of that view.

The first chart below shows the returns of the S&P 500 Materials sector and the S&P 500 Energy sector for this year, along with the relative performance (all indexed to 100 at the start of the chart), as of October 27th.SP500 Materials vs Energy Sector Returns

The collapse of the Energy sector this year has been historic, and comes after less extreme underperformance that was already occurring in 2019. The S&P 500 Energy sector total return index has declined -50% this year, by far the worst performing of the 11 major sectors in the S&P 500. This compares to the 6.5% gain for the S&P 500 overall.

The Materials sector, despite also being tied to global economic turbulence and commodity prices, has held up far better. Its year-to-date gain of 5.6% is only marginally behind the overall index, and vastly higher than that of Energy. And the relative outperformance trend has been consistent most of the year, both before the COVID-19 volatility in March and afterwards.

What explains the performance gap in these two commodity sectors?

First, the underlying commodities they are most closely tied to have followed very different paths this year. Crude oil prices are still far below their level at the start of the year (down about 40% for benchmark Brent crude), and even the current level of oil prices relies on the aggressive production cuts put in place by oil producers globally. So oil producers are facing the combination of lower prices and lower production, causing a severe drop in revenues. Naturally, the effects of severely depressed fuel usage due to COVID-19 travel limitations are a major factor in oil demand, and remain in place.

By contrast, industrial metals prices such as copper, aluminum, zinc, etc. (represented by the S&P/GSCI Industrial Metals index) have fully recovered their COVID-related decline and then some. Resurgent demand from China in particular as well as the strong US housing market have helped support prices for these metals used in manufacturing and housing, and are benefiting from the reflationary efforts of global central banks. Along with the increases in precious metals prices (gold and silver) this year, many of the stocks in the Materials sector have a relative tailwind to earnings from commodity prices.

Oil Industrial Metals

The effect of these divergent commodity price trends is also showing up in relative earnings estimate revisions activity. Analysts have been much more inclined to raise their earnings forecasts for Materials companies than for Energy companies, and that remains the case today. The chart below shows our aggregated relative earnings estimate revisions metrics for Materials versus Energy in the US. Readings above zero on the chart indicate more favorable analyst estimate revisions trends in Materials relative to Energy (red line indicates the relative proportion of analysts raising vs. lowering estimates, right scale; the blue bars indicate the average relative percent change in consensus estimates for the next 12 months, left scale). We can see that the readings are strongly in favor of Materials over Energy and have been for several months now.

US_Sect_RevSpread_Materials_Energy

With fundamental trends and relative returns both still pointing toward Materials over Energy within the commodity space, we would maintain relative positioning along those lines.