Energy Sector Is Heating Up

Summary

• Despite last year's oil price plunge, energy company earnings are strong.
• OPEC production cut is beginning to benefit crude oil prices.
• Energy stocks are poised to benefit from an oil price rally.

After the steep plunge in oil prices last year, many participants are inclined to ignore the beaten-down energy sector. Negative forecasts still abound among oil analysts, and some commentators have even called for short sales on crude oil despite its fourth quarter 2018 crash. As I'll argue here, though, the evidence - both technical and fundamental - strongly suggests that the energy sector is a buy and will surprise many observers with a strong performance in 2019.

For energy investors, 2018 was a year they'd like to forget. While Brent crude averaged $72 per barrel in 2018, according to the U.S. Energy Information Administration (EIA), oil prices finished the year lower than they started it. From a high of just over $75/barrel for West Texas Intermediate (WTI), crude oil prices fell dramatically in the fourth quarter, with WTI hitting one of its lowest levels in years at $43/barrel in December.

Source: Energy Information Administration

While oil's price performance last year was something most traders would like to forget, 2018 was in many ways a landmark year for the energy sector. According to EIA data, the U.S. surpassed Russia and Saudi Arabia early last year to become the world's largest crude oil producer based on monthly production statistics (below).

Source: Energy Information Administration

Meanwhile, crude prices have recovered some of their losses since December's low, with WTI hitting a 1-month high of $55.26 as of Feb. 1. The oil price rally since late December was partly a result of the market being technically "oversold" and short-covering has been clearly evident. From a fundamental standpoint, the production agreement announced Dec. 7 by OPEC and other countries, including Russia, would limit production by 1.2 million barrels a day from last October's levels. The agreement extends into the first six months of 2019.

The agreement to limit output seems to be working, for according to reports, OPEC oil supply fell in January by its largest amount in two years. According to Reuters, Saudi Arabia and its Gulf allies "over-delivered on the group's supply-cutting pact while Iran, Libya, and Venezuela registered involuntary declines."

With supply being rapidly cut, oil should be able to continue stabilizing and resume its recovery in the coming months. More importantly, the demand for oil should also increase based on the leading signals being flashed in the leading U.S. energy companies (which we'll discuss below). A deal to end the trade war between the U.S. and China, which is now under discussion, would almost certainly boost Chinese industrial demand for oil. Traders are clearly optimistic that such a deal can be reached before a March 2 deadline is triggered which would increase tariffs.

Let's now turn our attention to the recent performance of the energy sector compared with other major market groups. It's no secret that the Q4 2018 broad market decline resulted in significant improvement in equity valuations. The latest earnings season is also telling us that growth prospects for U.S. companies in most sectors are still positive. According to FactSet, the blended year-over-year earnings growth rate for the fourth quarter to date is 12.4%, while the blended yearly revenue growth rate for Q4 is 6.6%. Moreover, 10 of the 11 sectors are reporting year-over-year growth in revenues, while five sectors are reporting double-digit revenue growth, according to FactSet.

Looking deeper below the surface of the latest earnings reports yields some surprising insights. While it may seem counterintuitive based on last year's oil price plunge, the energy sector is actually leading the way for positive earnings surprises. The energy sector, moreover, is among those reporting double-digit earnings growth, and energy companies are also reporting the biggest positive difference between actual and estimated earnings. This is reflected in the recent liveliness evident in the Energy Select Sector SPDR ETF (XLE), which is finally emerging from its December doldrums. XLE is steadily recovering its losses from the last two months of 2018, and a near-term upside target of $70 seems reasonable based on earnings momentum and short-covering potential stronger technical resistance is encountered.

Source: BigCharts

Consider also that the March 2019 crude oil futures price (below) is threatening a decisive breakout above a 2-month trading range ceiling at the $55 level. If the oil price rallies decisively above $55 in the coming days, it will confirm that oil has commenced a new uptrend since this will result in a series of higher peaks. This, in turn, would likely generate additional short-covering, especially given how bearish many investors have become recently on the oil price outlook. More importantly, a sharp oil price spike in February would surely boost energy stock prices. Given how fundamentally attractive - and still technically "oversold" - the energy sector is, a crude oil price rally would greatly benefit energy stock investors.

Source: BigCharts

With an OPEC supply cut agreement firmly in place and the earnings outlook for U.S. energy companies looking much better, investors should think about allocating some of their portfolios to fundamentally sound energy companies. For ETF traders, a conservative long position in the Energy Select Sector SPDR ETF or similar energy ETF would be in order. For the XLE, I recommend using a point slightly under the $57 level as an initial stop loss (intraday basis). This represents a 12% decline from the most recent price quoted on Feb. 1 (which I consider to be the outermost limit of an acceptable loss for an ETF trading position). If the energy sector continues to show improvement in the coming months as I expect, additional commitments among individual energy stocks will be in order.

Analyst’s Disclosure: I am/we are long SPHQ, IAU, XLE. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.