Russia-Ukraine Crisis Triggers a Surge in Energy Shares

The Morningstar US Energy Index trounced the broad market in the first quarter, returning 43% versus the market's 5% decline. With the recent surge, we now view the sector as overvalued, with the median stock trading at an 11% premium.

Exhibit 1: Energy sector surges amid Russia-Ukraine conflict.

- source: Morningstar

While most segments are trading in overvalued territory, we still see opportunities in the oil-services segment, which trades at an average discount of 7%, suggesting the market chronically underestimates the level of investment needed to keep global oil supply in line with demand in the next few years.

Exhibit 2: Opportunities remain, especially in oil services.

- source: Morningstar

The rapid upswing in energy stocks was driven by the crisis in Ukraine, which has driven up crude and natural gas prices. The first wave of sanctions levied by the U.S., European Union, and United Kingdom were intended to be highly punitive without disrupting energy markets.

But by cutting off many Russian banks from the global financial system—including the Swift network—the sanctions also limited Russia's ability to receive payment for its exports, including crude. They also made global businesses and financial institutions extremely reluctant to transact with Russia, even in ways not explicitly targeted. The consequences could be even more severe if Western countries continue ratcheting restrictions. The U.S. has already directly banned crude imports from Russia, and the EU is seriously considering following suit (even though it gets 30% of its oil from there).

Exhibit 3: Russia accounts for about 10% of global supply.

- source: Morningstar

The disruption is likely to upend trade flows, with more Russian crude heading east, while volumes previously bound for Asia are diverted to Europe. But that creates frictions, including higher shipping costs, inefficient pipeline utilization, and quality mismatches at refineries. Russian crude has strong distillate yields, making it ideal for European markets where diesel is a popular transport fuel. European refiners would need higher volumes of alternate crude to derive the same volume of diesel, which artificially raises crude demand.

Exhibit 4: Russian crude steeply discounted against global benchmarks.

- source: Morningstar

The result is that crude and natural gas prices are likely to remain well north of our midcycle estimates this year ($55 per barrel for West Texas Intermediate crude and $3.30 per thousand cubic feet for U.S. natural gas). Outside Russia, supply is growing, but the market is unlikely to find balance before 2023 (perhaps longer if the conflict continues). OPEC, a Russian partner, has been struggling to hit its own targets, and U.S. sanctions remain in place on Iran and Venezuela for now.

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