Sizzling US energy stock rally confronts global growth worries

A scorching rally in US energy shares has left investors facing a tough decision: hold on despite growing worries that global growth will slow or lock in profits in one of the few areas of the stock market that has thrived this year.

The S&P 500 energy sector (.SPNY) has surged 55.7% year-to-date on the back of soaring oil prices, making it a welcome counterweight in portfolios during a year in which the broader S&P 500 (.SPX) has declined by 13.3%.

Some individual energy names have delivered returns more typically seen in high-flying technology over the past decade: Exxon Mobil Corp (XOM.N) and Chevron Corp (CVX.N) have gained 57% and 49% year-to-date, respectively, while Occidental Petroleum Corp (OXY.N) has soared about 140%. US crude oil prices have jumped 53% year-to-date, supporting oil and gas shares even as they help spur the steepest inflation in decades.

So far, energy shares have weathered hawkish pivots from the Federal Reserve and other central banks, which have stoked worries about slowing growth that could crimp energy demand. Still, there are signs some investors may be taking profits: while the sector is up 11% since late April, there have been five straight weeks of net outflows for energy sector funds overall, according to Refinitiv Lipper data.

"The fundamentals have really improved this year for the group," said James Ragan, director of wealth management research at D.A. Davidson. "The risks are that if we do go into some type of deeper recession globally that you could see some demand destruction."

Investors sticking with their energy bets cite the sector's strong earnings prospects, valuations that remain low on a historical basis and expectations oil prices will stay elevated following the conflict in Ukraine that tightened supply.

S&P 500 energy company earnings overall topped expectations in the first quarter and are expected to more than double in 2022, versus a 9% rise for the broad S&P 500, according to Refinitiv.

Companies in the 21-stock energy sector trade at 10 times forward earnings estimates overall, compared with a long-term median of 15.5 times, according to Refinitiv Datastream. The S&P 500 trades at about 17 times, by comparison.

Energy stocks "don't have a secular growth story like Tech, so investors only pay attention to these names when they are dramatically outperforming on the bottom line and estimates are going up," wrote Nicholas Colas, co-founder of DataTrek Research, in a recent note. "That is happening now and given how low 2023 estimates are we expect that will continue."

Some investors believe more disciplined capital spending from companies is adding support for the sector.

For example, 727 rigs are operating in the United States, according to the latest count from Baker Hughes , compared with more than 1,800 in mid 2014, when US crude last topped $100 a barrel.

"In prior cycles ... companies would be spending like drunken sailors to put new rigs in the ground and find oil," said Walter Todd, chief investment officer at Greenwood Capital, which owns stocks including Chevron and EOG Resources Inc (EOG.N). Now, "the cash-flow profile of these companies is like nothing we have seen in this space for a long, long time."

Others, however, are concerned demand may wane as China's economy is hit by coronavirus-related lockdowns or if the US economy slides into a recession – a possibility as the Fed pledges to tighten monetary policy until it tames inflation.

CFRA last month lowered its recommended exposure to the energy sector to "marketweight" from "overweight," saying that "as a result of the rising risk of recession or stagflation, CFRA thinks global demand will have a hard time remaining strong."

Shares could also suffer if investors rotate back in to technology or other areas of the market punished in this year's selloff. The energy sector is up some 40% over the past decade versus a roughly 450% gain for the S&P 500 technology sector (.SPLRCT).

Part of that underperformance has stemmed from investors shunning oil companies and fossil fuel for environmental reasons.

Still, investors are recognising that it may be a while before alternative energy sources become more widespread, said Hans Olsen, chief investment officer at Fiduciary Trust Company, who has a positive outlook on the energy sector.

"You have both a valuation argument and ... the operating environment we are in right now is really quite positive for the energy companies," Olsen said.