The energy sector serves as a safe haven during periods of geopolitical turmoil and is showing greater investment discipline. However, an increasing oil supply is dampening short-term expectations.
Investors in the energy sector are looking back on lean years. Over the past decade, the MSCI World Energy Index delivered an average annual return of 5.2 percent, compared to 10.4 percent for the global index. The sector only significantly outperformed the broader market in 2021 and 2022, when oil and gas prices surged following Russia’s invasion of Ukraine. As a result, most investors use the sector mainly for tactical positioning.
Investment manager Simon Wiersma of ING attributes the sector’s long-term underperformance to its composition of value stocks with limited profit growth. “The weight of American tech companies in the global index has grown significantly, and the growth rates in that sector are high. That’s why oil and gas stocks have fallen behind,” he explained.
Despite the energy transition, the sector still heavily relies on fossil fuels. “Although demand for oil and gas increases by a few percent annually, oil and gas prices are inherently very volatile. Compared to a year ago, the oil price is down nearly 17 percent, and we believe the market will become even more oversupplied,” said Wiersma. He pointed out that Opec+ has indicated plans to ramp up oil production again, while economic growth in the US is slowing and China is falling short of expectations.
Additionally, a possible ceasefire in Ukraine could make Russian oil more widely available, according to Wiersma. “That’s one reason why we recently downgraded the sector from neutral to underweight. On top of that, earnings expectations for the coming quarters are negative, and the market is only anticipating profit growth starting in the fourth quarter.”
Inflation hedge
On the other hand, Wiersma said the energy sector is a hedge against rising inflation expectations and an escalation of the conflict in the Middle East. “We’re seeing inflation expectations rising, particularly in the US. Market participants are hedging against higher inflation, which is a key driver of commodity prices. That made it difficult to lower our recommendation with full conviction. Still, in the short term, we see better opportunities in healthcare stocks, whose weight we’ve increased from neutral to overweight.”
In the medium term, the energy sector remains attractive to investors, as demand for oil and gas is expected to continue growing for now, Wiersma believes. “With more or less stable oil prices, they are solid value stocks thanks to the generous free cash flow the sector generates. While they do have to invest heavily in exploration and production, there’s still plenty of room for share buybacks and dividends. Especially in uncertain times like these, investors value that.”
Earlier this year, Wiersma recommended lagging European energy stocks. “From a valuation standpoint, we still find the European sector more attractive than the American one, although in the US there is more focus on shareholder value. As mentioned, we are currently underweight on the sector overall, and that includes the European players.”
Alastair Bishop, portfolio manager at BlackRock and manager of the BGF World Energy Fund, adds an important caveat to the sector’s weak track record on the stock market. According to him, the underperformance occurred mainly in the pre-Covid period, as in recent years the sector has performed in line with the global equity market. “In the past decade, the industry had access to a lot of capital and showed little discipline in its investments,” Bishop said. “Many companies prioritized growth over profitability. Combined with the rapid increase in US shale oil production, this created a volatile market with generally weak oil prices.”
After the pandemic, a fundamental shift occurred, as capital withdrawals from the sector led to greater discipline, Bishop explained. “Moreover, US shale oil production is now growing at a much slower pace, and rising inflation is boosting sentiment. The sector is positively correlated with high or rising inflation.”
He believes it is unfair that investors have yet to reward the sector’s improved performance with a revaluation. “Energy companies are delivering much higher returns than they did in the pre-Covid years, and their balance sheets are stronger than ever. In addition to returns on capital, returning capital to shareholders has also become a priority.”
Very attractive returns
According to Bishop, the sector has been undervalued by investors not only due to the lack of investment discipline but also because of the belief that oil and gas demand would soon peak. “But the market has underestimated the dominant role of fossil fuels in the energy system. Despite the rapid adoption of technologies to reduce CO₂ emissions, the energy transition takes a very long time. It’s certainly possible that oil demand will peak by the end of this decade, but that doesn’t mean demand will quickly decline afterward. Furthermore, gas demand hasn’t even come close to peaking.”
He believes analysts are too pessimistic in their discount models about how long oil and gas companies can generate cash flow. “On top of that, returns are coming in higher than they used to be, because less capital is available,” said Bishop.
According to him, the sector’s strong balance sheets allow for significant cash returns to shareholders through buybacks and dividends. “Assuming stable oil and gas prices and slight volume growth, shareholders can expect very attractive annual returns. For some large European players, that could even reach double digits. At the same time, the sector offers a very cheap hedge against tail risks like geopolitical shocks.”
Diversification and inflation protection are currently the main reasons why investors are looking to this sector, Bishop noted. “Compared to ten or twenty years ago, the MSCI World offers far less exposure to stocks that are positively correlated with inflation. Given the Trump-era import tariffs and rising tensions in the Middle East, that’s more important now than ever.”