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Quarter-End Insights

Russia-Ukraine Crisis Triggers a Surge in Energy Shares

Sector is pricey, but oil-services companies are trading at a discount.

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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.

Graphic comparing energy index and broader equity market.
  - 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.

Bar chart showing star rating distribution by energy subsector.
  - 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.

Chart showing the source of global oil 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.

Chart showing the steep discount in the price of Russian crude oil.
  - 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.

Top Picks

Schlumberger (SLB)
Star Rating: ★★★
Economic Moat Rating: Narrow
Fair Value Estimate: $49
Fair Value Uncertainty: High

Although rallying share prices have removed much of our oilfield-services coverage from deeply undervalued territory, investors can still get industry leader Schlumberger for a bargain. We expect industry activity to recover from COVID-19, with long-run activity in international markets (where Schlumberger focuses) even surpassing prepandemic levels. We think Schlumberger will continue its historical record of leading peers in technological progress and generating high returns on capital.

ExxonMobil (XOM)
Star Rating: ★★★
Economic Moat Rating: Narrow
Fair Value Estimate: $96
Fair Value Uncertainty: High

Exxon management responded to shareholder concerns and activist pressure by pulling the reins on its once-aggressive investment plan. However, it still plans to double earnings from 2019 levels by 2025 and double cash flow by 2027 on a combination of structural operating cost reductions, portfolio improvement, and growth across its upstream, downstream, and chemical segments. Exxon estimates that under the current plan, it will generate about

$100 billion in surplus cash, after funding investment and paying the dividend, during the next five years. As such, we expect its current repurchase program of $10 billion over the next 12–24 months to be just the beginning. This combination of potential earnings growth and cash return is unrivaled elsewhere in the sector.

Coterra Energy (CTRA)
Star Rating: ★★★★
Economic Moat Rating: Narrow
Fair Value Estimate: $33
Fair Value Uncertainty: High

Coterra is highly leveraged to both crude and natural gas prices, thanks to the merger of Cimarex (which focused on the Permian and Oklahoma) and Cabot (a Marcellus Shale pure play, producing exclusively gas). As such, it is one of the few U.S. producers with true commodity and geographic diversification and can roll with the punches by shifting capital wherever the returns are highest. The firm is currently benefiting from skyrocketing prices, though it is keeping production flat rather than growing to prioritize its generous capital returns program (comprising a base dividend currently yielding 2%, a variable dividend that ensures at least 50% of free cash is distributed quarterly, and a $1.25 billion buyback program).

Dave Meats does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.