Can The Energy Sector Continue Rallying?

Includes: XLE
by: Sankalp Soni

The Energy sector has rallied by about 14.33% since the start of the year amid a broad index rally.

Strong earnings growth in Q4 2018 has supported the sector in climbing higher, however the earnings outlook going forward is diminishing.

Certain weak fundamentals, an expensive valuation and a deteriorating global economy will undermine its performance going forward.

The Energy sector has been one of the best performers so far this year, with a YTD return of 14.33%, and has outperformed the S&P 500 index (12.59% return YTD). The sector delivered strong earnings growth last quarter, though worsening economic conditions and a potential recession ahead could undermine its strong performance going forward.

Source: Fidelity

What is Energy sector?

The Energy sector is a collection of two main industries that relate to oil & gas energy, such as the Energy Equipment & Services industry and the Oil, Gas & Consumable Fuels industry.

How does the sector perform during different phases of the business cycle?

The chart below demonstrates how the Energy sector is expected to perform during the different stages of the business cycle.

Source: Fidelity

The sector tends to perform poorly during the early stages, but is likely to outperform during the late stages, as it has done during the current late stage. According to Fidelity research, oil price performance is notably linked to inflation pressures, and that "as the economic recovery matures, the energy and materials sectors…have done well as inflationary pressures build and the late-cycle economic expansion helps maintain solid demand".

However, inflation levels have been rather weak lately, and remain below the 2% target. Hence, even though the Energy sector has been rallying during this late stage, it has done so in the absence of higher inflation pressures supporting oil prices.

Why has it outperformed?

One of the main reasons for the outperformance of the Energy sector is the fact that out of all sectors, it delivered the strongest earnings growth in Q4 2018. The sector was expected to deliver 75.7% earnings growth; instead it delivered 93.4% growth.

Source: FactSet

However, the earnings outlook going forward is not so appealing for the Energy sector, as 93% of companies have lowered their Q1 2019 earnings estimates. In fact, the sector's earnings growth forecast for this quarter has dropped from 16.2% to -13.4%, making it the sector with the largest drop in earnings expectations. Hence, this rally in the Energy sector may have gone too far given the deteriorating earnings outlook.

Furthermore, the Energy sector is also facing an oil oversupply, which is suppressing oil prices, with Brent Crude at $67.31 per barrel, and WTI Crude oil at $58.81 (at time of writing). Though oil prices have been recovering since the start of this year, as shown in the chart below, which has also played a role in allowing the Energy sector to rally higher. Nevertheless, it is still far below the highs reached in 2018.

Source: CNBC

OPEC and Russia have together been trying to drain this excess reserve through supply cuts, as in December 2018 they agreed to curb production by 1.2 million bpd, which will last till June 2019, and are anticipated to be extended through the second half of the year. On the other hand, the US has become the biggest oil producer, as the nation produced 11.7 million bpd in 2018, and has further increased its output this year to 12.1 million bpd. As a result, it has been offsetting the supply cut efforts by OPEC and Russia, and is inhibiting the excess supply from being drained more effectively.

Moreover, research from Fidelity finds that oil price declines that result from oversupply tend to have a worse impact on the Energy sector than declines that result from lower demand.

Source: Fidelity

Therefore, the persistent oversupply does not bode well for the Energy sector. Though the sector is not only challenged by an oversupply, but it is also facing a diminishing demand outlook amid deteriorating global economic conditions. Both the IMF and OECD have lowered their global growth forecasts lately, to 3.5% and 3.3% respectively. Moreover, Bernstein Energy has claimed "while they expect oil demand to rise by 1.3 million barrels per day (bpd) in 2019, a global slowdown could limit growth to below 1 million bpd". Thus given that global economic conditions are expected to worsen going forward, demand growth could indeed suffer, which will put downward pressure on oil prices and undermine the performance of the Energy sector.

In fact, the chart below demonstrates how the Energy sector has one of the highest international exposures. Hence given that the global economy is expected to continue slowing, it may not be advisable to continue holding exposure to this sector presently.

Source: Fidelity

The sector's fundamentals also portray a mixed picture, as it delivered the strongest EPS and EBITDA growth in 2018, however it recorded one of the weakest Return on Equity and Free Cash Flow margins during the same period.

Source: Fidelity

Return on Equity is a measure of how effectively corporations use shareholders' equity capital to generate profits. Given that it had been one of the worst performers on this measure during a period when it was delivering strong EPS growth is concerning given that EPS growth is anticipated to suffer going forward.

As I had addressed in a recent article of mine:

FCF is an important fundamental measure as it is used as an alternative profitability measure, and is a good indicator for how well the company is able to service its debts, maintain/grow dividend distributions to shareholders, and engage in R&D and large-scale expenditures to drive future growth and remain competitive. Moreover, amid a weakening economy (and a potential upcoming recession), sufficient FCF is even more essential in order to ensure it is able to repay debt effectively and maintain healthy financials.

Hence the poor FCF margin for the Energy sector is certainly concerning given that economic conditions are only anticipated to worsen, which will keep energy prices suppressed, and therefore undermine the ability of corporations in this sector to improve its cash flow conditions. This may negatively impact corporations' ability to repay debt at a time when it should be strengthening its balance sheet amid a potential recession ahead.

Furthermore, the Energy sector has also become expensively valued following this rally. It currently holds a forward PE ratio of 19.57, which is lofty in comparison to the S&P 500's 16.58 level (at time of writing). It is certainly unappealing to pay a higher forward multiple amid deteriorating earnings forecasts and increasing chances of a recession ahead.

Bottom Line

The Energy sector has rallied strongly since the start of the year, and has also outperformed the S&P 500 amid delivering strong earnings growth last quarter and improving energy prices. However, the earnings outlook ahead appears to be diminishing, while fundamentals and an expensive valuation are not supportive of a bullish case for the sector. I do not recommend buying into this rally in the Energy sector.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.