My favorite measure of the valuation of U.S. oil and gas stocks suggests that the huge gains seen over the past two years, and in particular since the start of 2022, have been entirely justified by the rising price of oil. I noted in October 2020 that U.S. energy stocks looked set to double relative to the S&P 500, due to a combination of oil price gains and the narrowing of the valuation gap between the energy sector and the broader market, which has now taken place.
However, the bulk of the outperformance of the energy sector over this time has been the result of the rise in oil prices, and the valuation gap remains extreme. This suggests the sector is still attractive on a relative basis, and should outperform in the absence of a downside reversal in oil prices. With this in mind, I remain long the Vanguard Energy ETF (NYSEARCA:VDE). The ETF seeks to track the performance of U.S. energy stocks as classified by GICS. The VDE is slightly more diversified than the larger Energy Sector Select SPDR ETF (XLE), with the two largest companies, Exxon (XOM) and Chevron (CVX), comprising 39% of the index versus 44% for the XLE. Meanwhile, the top 10 companies make up 67% of the index versus 76% for the XLE. While the VDE's dividend has dropped significantly thanks to the price rise, it still offers 3.1%, which is relatively attractive, particularly given the sector's recent performance as a hedge against increased geopolitical instability.
The chart below shows an update of the MSCI USA Energy sector's share of the MSCI USA index versus the ratio of WTI crude oil over U.S. Nominal GDP. As one would expect the two ratios follow each other closely as when oil prices rise oil and gas industry earnings tends to benefit, while other sectors of the market suffer. Despite the VDE's significant outperformance versus the S&P 500 over recent months, the MSCI USA Energy sector's market cap remains significantly below the level implied by current oil prices. This suggests that we should continue to expect VDE outperformance as the valuation gap closes, assuming oil prices remain at or near current levels. Even if the valuation gap does not close at all, the higher yield on the VDE relative to the S&P 500 should held drive outperformance.
Despite the energy industry's slow shift towards renewables, the price of crude oil remains the most important driver of earnings. According to Bloomberg analyst estimates, earnings and free cash flows are set to rocket to fresh all-time highs over the next 12 months, and as a result, the forward price/earnings and price/free cash flow ratios sit at just 11.0x and 11.2%. The rise in earnings estimates has been even steeper than the rise in equity prices, leaving valuations at new multi-year lows, and almost 50% below the S&P 500.
After seeing a spike to near all-time highs on the back the international response to the Russian invasion of Ukraine, the near-term price outlook will likely be beholden to geopolitical headline risk, and there is a high risk of a downside reversal given the scale of recent gains. However, the longer-end of the oil price curve has not seen much of a rise, with the price for delivery in two years’ time remaining only around half of its record high seen in 2008.
We are not seeing the same scale of panic buying by investors as we saw in 2008, despite the much more significant fundamental supply constraints, which suggests the rally is sustainable. The belief that declining developed market demand for hydrocarbons would keep prices low despite the mounting supply constraints has been fully upended by the Russian crisis.
The deep discount at which oil and gas stocks trade relative to the overall market could previously be justified to some extent by the rise of ESG-focused investing and the tendency for the sector to perform poorly during recessions due to the high sensitivity of earnings to oil prices. These factors suggested that the valuation gap may remain in place indefinitely. However, there is also now a case to be made that the sector should trade at a premium to the market as it offers investors a hedge against continued geopolitical shocks and stagflation. As the chart below shows, the VDE and the S&P500 have been strongly inversely correlated over recent months.
Despite the significant gains seen in the VDE over recent months, the rally in energy prices suggests these gains are justified. In fact, the underlying MSCI USA Energy sector's valuation discount relative to the broader market is at multi-year highs thanks to surging earnings and free cash flow expectations. Considering that the sector continues to trade inversely to the S&P 500 due to heightened geopolitical tensions, the current valuation discount seems unsustainable.
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Disclosure: I/we have a beneficial long position in the shares of VDE either through stock ownership, options, or other derivatives. 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.