Summary
- Even though the S&P 500 energy sector is up 41% in 2022 (vs. -17% for the broader index), we recommend an overweight position.
- If analyst earnings and free cashflow projections pan out, energy equities could double or even triple from present levels over the next year.
- Even if analysts are overly optimistic, between high energy prices and energy companies prioritizing free cashflow over CAPEX, energy companies are likely to generate strong earnings and free cashflow growth in 2022. This should ensure energy equities keep outperforming the S&P 500.
Market Implications
- Given the myriad uncertainties about Ukraine, inflation and the global economy, investors will likely wait to bid up energy equities further until they see higher earnings and cashflow.
- The key risk for energy equities is a collapse in energy prices.
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Summary
- Even though the S&P 500 energy sector is up 41% in 2022 (vs. -17% for the broader index), we recommend an overweight position.
- If analyst earnings and free cashflow projections pan out, energy equities could double or even triple from present levels over the next year.
- Even if analysts are overly optimistic, between high energy prices and energy companies prioritizing free cashflow over CAPEX, energy companies are likely to generate strong earnings and free cashflow growth in 2022. This should ensure energy equities keep outperforming the S&P 500.
Market Implications
- Given the myriad uncertainties about Ukraine, inflation and the global economy, investors will likely wait to bid up energy equities further until they see higher earnings and cashflow.
- The key risk for energy equities is a collapse in energy prices.
Introduction
In a year marked by ongoing downside for equities, the energy sector is the star, posting a 40.7% return year to date. Yet unlikely as it may seem, there is further upside. This is partly because of high oil and gas prices, but primarily because energy companies are now prioritizing free cashflow and returning capital to investors instead of pursuing speculative exploration and production-related CAPEX.
In this article, we highlight how industry fundamentals are shifting and the implications for energy sector equities over the next year. A recent note from Josh Young covers some of the same ground and offers several trading ideas.
The Energy Sector Has a Volatile History
A quick glance at the energy sector subindex of the S&P 500 (SPX) shows its price and earnings per share (EPS) has been extraordinarily volatile relative to the SPX over the past 20 years (Chart 2, 3).[1]
In the coming year, equity analysts are forecasting the earnings per share (EPS) for the energy index to jump 48%, compared with 14% for the SPX. The energy sector projections reflect continued high energy prices and the trend to deemphasise CAPEX in favour of free cashflow.
We note that analysts’ projections tend to be good unless there is some unexpected shock in the coming year such as a recession or financial crisis, or in this case, a collapse in energy prices, perhaps because of a major influx of new supply.
At this point, energy equity valuations do not reflect anything like this earnings scenario.
P/E Ratio Suggests Energy Equities Are Cheap
When energy companies are profitable, P/E ratios tend to be somewhat lower than the broader SPX P/E (Chart 4, axis truncated). During the boom years of the aughts, the SPX forward P/E was some 25 to 50% higher than the energy sector. After the financial crisis, the SPX P/E was 10-20% higher than the energy sector until oil prices collapsed in 2015.
Currently, the S&P forward P/E is a 75% higher than the energy sector. Assuming no crisis or major shift in energy supply dynamics, we expect this gap will tighten in coming months – either because the SPX P/E ratio falls further or the energy P/E rises. Assuming analysts’ EPS projections are reasonable and the SPX/Energy P/E ratio tightens to less than 50%, the energy index could more than double.
Cashflow Metrics Are More Robust
The most direct way to appreciate the shift in energy company focus away from CAPEX is to compare cashflow with free cashflow (FCF) measures (Charts 5 and 6). The difference is CAPEX. SPX CAPEX was near 40% of cashflow for the past decade before dropping to about 35% during the pandemic years.
In the energy sector, FCF hovered near zero for much of the past 20 years. Energy companies ploughed most of their cashflow into exploration and production to maintain and build reserves.
In the past two years, energy CAPEX as a percent of cash flow has dropped to 30%.
One consequence is the FCF yield, whether on a trailing or forward basis, has jumped to record levels (Chart 7). Since the Global Financial Crisis (GFC), the forward FCF yield traded near 4% during good times; now it is above 12%. Theoretically, if forward cashflow projections were to be realized and energy equities repriced to a 4% FCF yield, the energy index would triple. We return to this point below.
Anecdotal Evidence Confirms the FCF Focus
During 1Q earnings season, oil and gas companies mostly focused on improvements in FCF and plans to limit CAPEX activity in coming quarters, or not to exceed 2021 CAPEX levels. Others increased share buyback plans. Notably absent was any intention to capitalize on high energy prices by ramping up production.
This posture reflects an understanding by both investors and energy companies that the threat of global warming is turning the tide – however slowly – away from fossil fuels. To increase exploration and reserves is to risk sinking capital into what will become stranded assets at some point – fossil energy reserves that cannot be extracted and exploited as the share of green energy grows.
Investors Take a Wait-and-See Stance
We have suggested that in an ideal world, energy equities could more than double or triple over the next year based on historical P/E and FCF yield relationships, respectively. An ideal world implies myriad assumptions, including oil prices remaining near $100; energy companies remaining focused on FCF; analysts’ projections turning out to be on the mark; and no major economic crisis or recession.
Of course, investors are sceptical about these assumptions. Even if they buy into the narrative that energy companies will not return to previous CAPEX ways, there is a massive cloud of uncertainty ahead about energy prices, central bank policy and the economy.
To the extent these assumptions play out, the energy index and equities should benefit proportionately. We expect investors will price in rising earnings and FCF as it becomes more apparent whether and what is reasonable.
Another bullish indicator is that the energy sector market cap is a scant 4% of the SPX. Even an aggressive overweight will still amount to a relatively small allocation. To the extent investors capitalise on strong underlying fundamentals and aggressively overweight energy, that will further boost relative returns – while still representing a small overall asset allocation if things go wrong.
The primary risk in this trade is a sharp and sustained drop in energy prices. That could occur if the Ukrainian war ends in a way that Russian oil and gas returns to the market; or there is a major economic contraction; or energy companies resume exploration and production CAPEX.
Appendix – Summary of SPX Energy Sector
[1] The Bloomberg ticker for the S&P 500 Energy Sector is IXETR Index. It is tradable via the XLE ETF. The S&P 500 index is tradeable via the SPY ETF. In a Appendix we summarize the constituents of the IXETR index.