Energy companies—both large and small—have been beating the broader stock market in 2019, but have largely missed out on the oil rally, which has seen the Brent crude price surge 29% year to date. On Tuesday, both Brent and West Texas Intermediate hit their highest closing prices since November.
The energy sector’s share of the overall market is smaller than it has been historically, but its valuation isn’t cheap, due to recent downward revisions in earnings estimates. Nicholas Colas of Datatrek suggests in a Wednesday report that energy investors should look beyond price and valuation for other narratives to decide on a strategy for the sector.
The back story. Energy stocks currently represent 5.4% of the
total market capitalization. According to Colas, that’s way down from an average weighting at 9.6% since 2000. “Energy sits at unusually low weightings—ones that ‘should’ only occur in 2.5% of the time,” wrote Colas.
Oil prices don’t seem to be the reason for energy’s low weighting. West Texas Intermediate crude closed at about $63 a barrel on Tuesday. Historically, when prices are near $60 per barrel—in bull or bear commodity markets—energy stocks have made up a larger part of the S&P 500 index than they do today. For example, according to Colas, 8.8% in July 2015, 14.4% in November 2008, 12.6% in May 2009, and 8.4% in December 2014.
Bigger large-cap tech companies can’t be solely blamed, either, since the energy sector’s share in mid-cap and small-cap indexes has been shrinking, as well. Energy only represents 3.9% of the
S&P 400 Mid Cap Index,
4.5% of the
S&P Small Cap 600 Index,
and 3.8% of the
according to Colas.
The plot twist. Oil prices have climbed this year on signs of reduced global supplies—thanks to pledged production cuts by OPEC and other major oil producers—and fading worries over global economic growth.
Energy stocks have risen, too, although not as much as oil prices. As of Tuesday’s close, the energy sector in the S&P 500 has increased 16.2% year to date, beating the broader index by 1.8 percentage points, while small-cap energy stocks surged 24%, exceeding the S&P 600 by 12 percentage points.
The outperformance comes even as Wall Street analysts have slashed revenue and earnings estimates for the sector. Analysts now expect the group to post the worst revenue growth in 2019 of any S&P 500 sector, wrote Colas, revising their outlook to a 4.7% decline from growth of 4.3% at the start of the year. For earnings, analysts now expect the sector to see a decline of 11.9% from last year, adjusted from 8.6% growth in early January.
As a result, energy stocks in the S&P 500 aren’t cheap. They now trade at 18 times 2019 earnings, higher than the 16.3 times for the broader index, according to Colas.
Moving forward. Colas thinks the dichotomy in the sector’s pricing might be a result of greater technology investment in the industry over the past decade, which has changed how investors perceive and value energy stocks.
Technology has improved companies’ operating efficiency and allows for greater production, which means the sector should outperform as oil prices go up. On the other hand, however, technology has facilitated the development of alternative new energy sources, which brought more competition to the space and therefore likely contributed to analysts lowering earnings estimates.
“The technology investment narrative can easily trump old-school ideas like valuation,” wrote Colas.
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