Personal Wealth Management /

Tempted by Energy Stocks' Heat? Be Careful.

We think chasing Energy’s hot returns may end up leaving your portfolio feeling cold.

Whilst global markets have endured a correction (a sentiment-driven decline of around -10% to -20%) this year, one sector hasn’t participated: Energy.[i] Global Energy stocks are up just over 37% year to date.[ii] This is generating a host of chatter about a long-lasting leadership rotation from financial commentators we follow. In our experience, this runs a high likelihood of spurring fear of missing out—FOMO—amongst investors whose portfolios followed the broader market’s swings. Dear readers, let us issue a friendly reminder: You can’t buy past returns. Moreover, what just led isn’t guaranteed to keep leading. So if Energy’s run is tempting you to surrender a diversified portfolio for a concentrated position, we suggest taking a deep breath and staying cool. In our view, discipline is key to successful investing.

Whenever past performance makes you want to trade, we think it helps to pause and go back to basics. Consider what we think is one of the first principles of investing: Past performance doesn’t predict future returns. What happened one month doesn’t determine what happens the next. Just because something did very well doesn’t mean it will stay atop the leaderboard. Our historical analysis shows leadership shifts often.[iii] Sometimes those shifts are lasting, resulting in cumulative outperformance over a few years.[iv] Sometimes they are quick deviations in leadership.[v] If you chase them, we think you run the risk of missing returns if the hot sector turns cold.

For a recent example, consider Energy stocks last year. Then, as now, they were the hottest sector early on. When Q1 2021 ended, global Energy stocks were up 20.7% on the year.[vi] The MSCI World, by contrast, was up just 4.0%.[vii] According to many financial commentators at the time, Tech stocks were out, and Energy stocks were in. But the party didn’t last. Energy stocks were basically flat over the next several months and underperformed for much of the rest of that year.[viii]

Discerning a temporary, sentiment-driven leadership reversal from a more lasting, fundamental leadership reversal is one of the toughest tasks around, in our view. In our experience, it requires clear thinking free of emotion. The task: understanding why a given category did well and assessing whether it is likely to last. In this case, we think Energy got a big boost from oil prices’ spike—in our view, a sentiment-driven reaction to Russian President Vladimir Putin’s Ukraine invasion and the risks many financial experts argued it posed to oil supply.[ix] As the US blocked Russian oil imports, European nations debated about doing the same and companies self-sanctioned, we think it drove concerns of a severe global shortage. Financial publications warned producers in the US, OPEC nations and elsewhere wouldn’t or couldn’t crank up production to offset Russia’s absence from global oil markets. The prospect of tight supply as the world ended Omicron restrictions—raising demand for oil—sent crude above $100.[x] Since our research shows Energy companies’ earnings are sensitive to oil prices, we think Energy stocks rallied in anticipation of a big boost to profits.[xi]

Thing is, this is all in the past. Our research shows stocks discount all widely known information quickly. If spiking oil prices and a global oil shortage are the crux of your reasons for loading up on Energy stocks now, we think you risk trading on widely known information that is already incorporated in Energy stock prices. Even if that thesis comes true, our research shows stocks move most on surprises. We are hard pressed to see much surprise power left in the prospect of $100-plus oil boosting Energy companies’ earnings.

Instead, we see a risk of disappointment. In our view, sentiment played a large role in oil prices’ spike—it seemingly stemmed more from warnings from financial commentators of what might happen to oil markets than a realistic assessment of how oil supply and demand were likely to evolve. We are already seeing some indications that supply won’t be as tight as people presumed a month ago. Last week, BBC News reported that India is stepping up its purchases of Russian oil.[xii] China, too, is reportedly buying.[xiii] When they buy more from Russia and less from Middle Eastern producers, simple logic suggests it leaves the latter with additional supply to sell to the US and Europe. If you will pardon the industry jargon, oil markets are fungible—buyers and sellers are interchangeable to a fairly significant degree. The more oil Russia is able to sell to the remaining nations and refiners willing to do business with a sanctioned state, the more non-Russian supply it frees up for the rest of the world to buy. As these trade relationships shift and adjust, we think it is likely to help prices stabilise—especially as all the new wells drilled in the US over the past several months continue coming online and adding to production.[xiv]

Yes, we have seen the many reports throughout the financial news world saying US Energy companies don’t plan to increase investment beyond what they have already budgeted for this year. But, in our view, that doesn’t mean much—production was already set to increase under existing plans: The US Energy Information Administration forecasts US oil production rising to an average of 12 million barrels per day (bpd) this year and hitting a record-high 13 million bpd in 2023.[xv] Whilst this forecast is widely available, based on our read of the Energy sector news coverage right now, we think it is also underappreciated, which suggests to us people loading up on Energy stocks now could be caught off guard by falling oil prices and weaker-than-expected earnings.

We get that Energy’s recent returns are alluring, but you can’t go back in time and get them. Moreover, even after its recent run, the sector is just 4.3% of MSCI World Index market capitalisation—tiny.[xvi] We think owning some Energy stocks is likely beneficial for diversification, but we don’t think amassing a large overweight is likely to add much value over the foreseeable future. Energy’s time will eventually come, but we think it will probably happen when the sector is far less loved than it is today.

[i] Source: FactSet, as of 28/3/2022. Statement based on MSCI World Index return with net dividends in GBP, 31/12/2021 – 25/3/2022.

[ii] Ibid. MSCI World Energy Index return with net dividends in GBP, 31/12/2021 – 25/3/2022.

[iii] Ibid. Statement based on MSCI World Index sector, region and country returns with net dividends.

[iv] Ibid.

[v] Ibid.

[vi] Source: FactSet, as of 28/3/2022. MSCI World Energy Index return with net dividends in GBP, 31/12/2020 – 31/3/2021.

[vii] Ibid. MSCI World Index return with net dividends in GBP, 31/12/2020 – 31/3/2021.

[viii] Source: FactSet, as of 28/3/2022. Statement based on MSCI World Energy Index return with net dividends in GBP, 31/12/2020 – 31/12/2021.

[ix] Ibid. Statement based on Brent Crude Oil spot prices.

[x] Ibid.

[xi] Source: FactSet, as of 28/3/2022. Statement based on MSCI World Energy Index return with net dividends in GBP, 31/12/2021 – 25/3/2022.

[xii] “Ukraine: India ‘Feeling the Heat’ Over Neutrality,” Soutik Biswas, BBC News, 25/3/2022.

[xiii] “China’s Sinopec to Keep Buying Russian Oil and Gas, Exec Says,” Kenji Kawase, Nikkei Asia, 28/3/2022.

[xiv] “Drilling Productivity Report,” Energy Information Administration, 14/3/2022.

[xv] “Short-Term Energy Outlook,” US Energy Information Administration, 3/8/2022.

[xvi] Source: FactSet, as of 24/3/2022. Market capitalisation—share price multiplied by the number of outstanding shares—is a measure of a company or index’s total value.

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