Energy stocks have taken Wall Street by surprise in 2024. Here's what it will take for them to keep climbing.

By Joseph Adinolfi

Rising crude-oil prices have helped push energy stocks to record highs for the first time in nearly a decade. But it will take more than that to keep the rally going.

Back in December, few Wall Street analysts expected energy stocks would outperform the Nasdaq-100 in 2024.

But much to the surprise of professional stock pickers, the sector has become an unlikely leader. And analysts who closely follow it believe the latest bull run is still in its early innings, as Wall Street warms to energy stocks and fund managers who had previously shunned them play catch up.

The sector won a key vote of confidence last month when Morgan Stanley's Michael Wilson recommended that clients dial up their exposure to the sector in a report viewed by MarketWatch.

"There's no doubt in my mind that energy outperformance has surprised a lot of people this year," said Leo Mariani, a senior research analyst at Roth MKM who focuses on oil-and-gas exploration and production companies, during an interview with MarketWatch. "I definitely think that a lot of folks are taking a harder look at it."

A fresh record high after nearly 10 years

On Wednesday, the S&P 500 energy sector XX:SP500.10 hit a record high for the first time since June 2014, according to Dow Jones Market Data.

Following this latest milestone, the Energy Select Sector SPDR Fund XLE is now up nearly 16% since the start of the year as of Thursday's close, compared with a 6.3% gain for the Invesco QQQ Trust I QQQ, which tracks the Nasdaq-100 NDX, according to FactSet.

The sector's gains have been lead by shares of oil refiners, including shares of Marathon Petroleum Corp. (MPC) and Valero Energy Corp. (VLO), which were up 45.8% and 38.9% through Thursday, respectively. Refiners have benefited from increasingly favorable spreads between the price of oil and its distillates like gasoline and low-sulfur diesel, analysts told MarketWatch.

But gains have been widely distributed across the sector's sub-industries, from exploration and production to equipment and services. As of Thursday's close, only three of the 23 stocks in the S&P 500 energy sector were trading in the red for the year.

Energy stocks are also outpacing the S&P 500's SPX 7.9% gain this year to date after the sector emerged as the top performer among the index's 11 sectors in March. So far this year, the sector is the second-best performer after only the megacap-tech-heavy communication-services group XX:SP500.50.

Rising crude prices help drive energy stocks higher - but they're not the only reason

Much of the sector's advance in 2024 has been driven by rising crude-oil prices, which settled at their highest levels since October on Thursday.

Brent crude (BRN00) settled at north of $90 a barrel on Thursday, while West Texas Intermediate crude (CL00) settled above $86 a barrel, according to FactSet data.

But that's not the only factor driving energy stocks higher. Investors have also been drawn to energy names as the outlook for the global economy has brightened, Mariani said. Attractive valuations relative to the increasingly expensive S&P 500 have also boosted their appeal.

Analysts have pointed to attractive free-cash-flow yields and enterprise-value-to-Ebitda (earnings before interest, taxes, depreciation and amortization) ratios as signs that the sector represents a good bargain relative to the broader S&P 500.

The XLE fund has a free-cash-flow yield of 7.9%, according to FactSet data, compared with 4.1% for the S&P 500 as a whole.

Meanwhile, the sector's enterprise-value-to-Ebitda ratio stood at 6.8 times on Thursday, compared with 14.2 times for the broader index - signifying that investors are getting a good bargain based on the sector's expected earnings.

Geopolitical tensions have also played a role, and the threat of a broader conflict between Israel and Iran could help propel shares of U.S.-traded oil-and-gas firms even higher in the near term along with prices of crude oil, Mariani said.

Oil prices jumped this week as simmering tensions between Israel and Iran threatened to boil over after Israel attacked Iran's consulate in Syria. Analysts attributed a sharp spike in oil prices on Thursday afternoon to fears about Iranian retaliation.

Only the strong survived

Prior to the sector's comeback in 2022, persistently low crude prices, coupled with the widespread conviction that renewable energy was destined to supplant fossil fuels, weighed on oil-and-gas stocks for years.

As Wall Street increasingly focused on environmental, social and governance concerns, big banks shunned the sector and companies in the space became starved for capital, analysts said.

Many went bankrupt or were forced to merge with rivals, said Jeremy McCrea, an equity-research analyst at BMO Capital Markets who has long followed the energy sector. Data from S&P Global show oil-and-gas firms have accounted for 17.4% of the 195 U.S.-based corporate bankruptcies since 2014.

To survive, energy companies had to become more judicious about capital expenditures. They paid down debt and returned more money to shareholders in the form of buybacks and dividends, McCrea noted. This strict capital discipline is part of what makes energy stocks so attractive to investors today.

What will it take to keep the rally going?

Energy prices are inherently cyclical in nature, so it is natural that energy stocks would rise and fall as the strength of the economy waxes and wanes.

But if these stocks are to hold on to most or all of their recent gains, investors must continue warming to the idea that oil and gas will remain an indispensable part of the global energy mix for the foreseeable future, McCrea said.

Investors' attitudes have already shifted dramatically.

"Sentiment was so awful back in 2020, 2021," McCrea said. "Now you're getting new investors coming in to the sector."

"It shows there could be a lot more life to this," he added.

-Joseph Adinolfi

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04-05-24 0700ET

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