Geopolitical risks driving up oil prices could potentially position the energy sector for a comeback after lagging behind the rest of the US stock market for months.
The S&P 500 energy index (.SPNY) has dropped nearly 3% since late October, while the broader S&P 500 (.SPX) has surged 16%. The energy sector was the second-worst performer among S&P 500 sectors in 2023, falling 4.8%, as oil prices plunged over 20% in the same period.
But some bullish investors are betting that the tide is about to turn for energy shares, as a recent flare-up in the Red Sea threatens to disrupt global oil supplies and boost demand for US crude.
Red Sea Conflict Sparks Oil Rally
On Friday, US and British forces launched air and sea strikes on Houthi targets in Yemen, in response to a series of attacks by the Iran-backed rebels on Saudi oil facilities and vessels. Several oil tankers diverted course from the Red Sea, a vital shipping route for crude exports from the Middle East.
The news sent US oil prices soaring as much as 4.5% before settling up 0.9%, to around $73 a barrel. The energy sector gained 1.3% on the day, outperforming the S&P 500, which rose 0.4%.
“While a resolution of the problems in the Red Sea would be bearish for oil, it appears as though the situation is escalating and the risk should drive oil prices higher,” wrote Mike O’Rourke, chief market strategist at JonesTrading.
Concerns about oversupply, especially from the US shale industry, and weak demand from China and Europe amid the ongoing pandemic have weighed down the global oil market. The Red Sea conflict has added to the uncertainty surrounding it.
Energy Earnings and Valuations in Focus
Another key factor for the energy sector’s prospects will be the upcoming quarterly earnings reports, which kick off next week with oil services firm SLB (SLB.N), formerly known as Schlumberger. Other major energy companies, such as Baker Hughes, Marathon Petroleum (MPC.N), ConocoPhillips (COP.N), and Chevron (CVX.N), are expected to report later this month.
Analysts expect the energy sector to post the worst full-year 2023 earnings performance of any sector, falling nearly 26%, according to LSEG data. But they also project a 1.6% increase in 2024, slightly above the 1.4% growth forecast for the S&P 500.
Some investors see value in the energy sector, which trades at around 10 times trailing earnings, compared to 22 times for the S&P 500. Strategists at the Wells Fargo Investment Institute (WFII) this week upgraded their rating on the energy sector to “favorable” from “neutral,” citing “historically cheap” valuations and a positive outlook for oil prices.
WFII expects oil prices to bottom with the global economy and then finish the year higher, as demand recovers and supply remains constrained by OPEC’s production cuts and US sanctions on Iran and Venezuela.
A Hedge Against Geopolitical Risks
Some investors also view energy shares as a hedge against geopolitical risks, which could spark inflation and hurt other sectors of the economy. Walter Todd, chief investment officer at Greenwood Capital, said his firm is overweight energy in its portfolios, as he believes the sector offers attractive returns and diversification benefits.
“I think there are a lot of reasons to own energy right now, not just because of the Red Sea situation, but because of the fundamentals of the industry and the valuation of the stocks,” Todd said.
However, not everyone is convinced that energy is a good bet. Robert Pavlik, senior portfolio manager at Dakota Wealth Management, said he thinks oil is fairly priced, and doubts the Middle East conflict would have a lasting impact on the commodity. Pavlik said he has “slightly less than market exposure” to energy shares, preferring other sectors such as industrials and technology.
“I think there are other areas of the market that will benefit most likely more than energy,” Pavlik said.
Despite the challenges and uncertainties facing the energy sector, some analysts remain optimistic that it can overcome the headwinds and deliver strong performance in 2024.
Source: Reuters
