Written by: David Lebovitz , Global Market Strategist, JP Morgan Asset Management
The S&P 500 energy sector has lagged the strong performance of the broader index, falling by over 6% so far this year. Energy remains unloved for a number of reasons – value investors don’t think it is cheap enough, and growth investors don’t see the future upside – but we believe that there is good reason to be optimistic that better times may lie ahead.
First, global oil markets have come into balance. When investors talk about commodities, they often highlight whether the “curves” are in backwardation or contango – in other words, whether today’s prices are higher (backwardation) or lower (contango) than future months. Curves in contango suggest that oil is oversupplied, as current months trade at a discount to future months; until recently, oil markets have been in contango for the better part of the past three years. However, as the global oil supply/demand dynamic has gradually come back into balance, current prices have risen above future prices, reflecting a tightening in oil supplies. Importantly, and as shown in the chart below, there is a significant relationship between the slope of the commodities curve and the performance of energy stocks. With the slope of the curve back in positive territory and steepening, energy stocks could be set to outperform.
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Second, corporate fundamentals are improving. Healthier earnings and more optimistic outlooks across mid and downstream businesses suggests that the energy sector broadly is beginning to stabilize. Furthermore, a number of upstream companies have announced significant reductions in future CAPEX plans, while downstream businesses are focusing on distributing capital to shareholders. This combination of a more responsible operating mentality combined with shareholder-friendly activities suggests that better times may lie ahead for the energy sector.
In a world where both stocks and bonds look expensive, investors will need to focus on relative value. The energy sector appears to be one source of such value today.
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