Can Energy Stocks Close the Performance Gap with the S&P 500?
July 25th, 2024 | Posted in InvestingCan Energy Stocks Close the 10-Year Performance Gap with the S&P 500?
The Energy sector has been topsy-turvy over the past few years. In 2022, when the S&P 500 experienced a bear market and 9 of 11 sectors posted negative performance, the Energy sector delivered a banner year (+65.7%). The next best performer that year was Utilities, which rose a meager +1.6%. Energy was also the best-performing sector in 2021, rising +54.6%.
But it hasn’t been a period of straight-line gains for the Energy sector. In 2023, Energy flipped back to being the second worst-performing sector in the S&P 500, falling -1.3%. Utilities was the worst performer that year, posting a -7.1% decline.
If investors look at the last three years, the Energy sector has delivered annualized returns of +17.64%, compared to the S&P 500’s +8.56% annualized return over the same period. While that may seem very strong, zooming out further to 5-year or 10-year annualized returns shows Energy lagging the S&P 500 index by a significant margin. Over the past 10 years, for instance, Energy’s annualized return is flat, while the S&P 500 has delivered slightly over 10% annualized.1
This historical look at Energy sector returns is meant to frame the question: Can Energy stocks close the 10-year performance gap with the S&P 500?
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Let’s start with the counterargument—i.e., why Energy stocks could continue to lag.
By some estimates, supply and demand dynamics looking forward are working against the Energy sector’s current makeup, which is dominated by oil and gas companies. According to the International Energy Agency (IEA), oil demand is set to peak in 2029 at around 100 million barrels a day, giving way to declines as renewable energy sources proliferate and as global consumers continue shifting to electric vehicles (EVs).
On the supply side, the IEA predicts that oil production will surge past demand, increasing to 113.8 million barrels a day driven largely by the United States and South American countries. The end result, according to the IEA, is “levels of spare capacity never seen before other than at the height of the Covid-19 lockdowns in 2020.” 3
When supply outstrips demand by this wide of a margin, price pressures can crush margins and earnings for major companies in the Energy sector. This is what’s driving a bleak long-term performance outlook relative to the broad S&P 500.
We see a couple of issues with this stance on the Energy sector, however.
The first is that we think it’s ineffectual to try and forecast supply and demand more than a year or two into the future. Projecting what oil demand will be in 2029 means baking in too many assumptions about economic growth, trends in the energy transition, consumer behavior, geopolitics, and so on. There is simply no way to know how the energy mix will look five years from now. The IEA acknowledged as much in their report, stating that economic growth trends and EV adoption were risks to their forecast.
The second is that global economic growth has been resilient, and in the case of the United States, has been stronger-than-expected in the past couple of years. China and Europe have struggled to deliver strong growth during this period, but economic indicators in 2024 are showing improvement. Better-than-expected economic growth tends to drive higher-than-expected energy demand, which can provide support to oil prices and profit margins in the process.
A constructive view of the Energy sector would also point to current valuations as a reason to be optimistic. Of the 11 S&P 500 sectors, Energy is the cheapest in terms of forward P/E. The sector trades at 11x forward earnings, which is lower than every other sector and also is well below Energy’s longer-term forward P/E of roughly 17x.
Finally, there’s a geopolitical component. Looking at the current conflicts in the Middle East and Ukraine, it seems fair to say that these conflicts are unfortunately showing few signs of abating. Oil production is global, so regional conflicts do not tend to have a substantial impact on global supply. But we have seen price volatility in the wake of crises, and ownership of the Energy sector might be viewed by investors as a hedge against geopolitical risk.
Bottom Line for Investors
In our view, stronger-than-expected global economic growth—combined with attractive valuations—should bolster the outlook for the Energy sector looking forward. This does not necessarily mean taking a major overweight position to Energy in equity portfolios. But we do see a strong case for including Energy stocks as a key component of diversified portfolios, despite recent IEA forecasts suggesting that oil supply is poised to outstrip demand later in the decade.
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2 Zacks Investment Management may amend or rescind the A Better Way Forward: Actively Managing Passive Index Funds guide offer for any reason and at Zacks Investment Management’s discretion.
4 Zacks Investment Management may amend or rescind the A Better Way Forward: Actively Managing Passive Index Funds guide offer for any reason and at Zacks Investment Management’s discretion.
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Zacks Advantage is a service offered by Zacks Investment Management, a wholly-owned subsidiary of Zacks Investment Research. Zacks Investment Management is an independent Registered Investment Advisory firm and acts as an investment manager for individuals and institutions. All material in presented on this page is for informational purposes only and no recommendation or advice is being given as to whether any investment or strategy is suitable for a particular investor. Nothing herein constitutes investment, legal, accounting or tax advice. The information contained herein has been obtained from sources believed to be reliable but we do not guarantee accuracy or completeness. Zacks Investment Management, Inc. is not engaged in rendering legal, tax, accounting or other professional services. Publication and distribution of this article is not intended to create, and the information contained herein does not constitute, an attorney- client relationship. Do not act or rely upon the information and advice given in this publication without seeking the services of competent and professional legal, tax, or accounting counsel.