One of the surprises of 2017 was the relatively poor performance of stocks making up the energy sector of the MSCI World developed market equity index (see Exhibit 1). The sector gained just 4.2% last year, compared to the 23.1% advance for the broader index. This shortfall is surprising as the principal driver of returns for energy sector stocks – crude oil prices – ended the year up by more than 20%.
Exhibit 1: Developed world equity total returns in 2017: energy sector lags
Note: Index is MSCI World IMI. I-T = Information Technology, MAT = Materials, IND = Industrials, C-D = Consumer Discretionary, FIN = Financials, HLT = Health Care, C-S = Consumer Staples, RST = Real Estate, UTY = Utilities, TEL = Telecommunications Services, EGY = Energy. Returns in USD. Source: FactSet, BNP Paribas Asset Management, as of 05/01/2018
The fall in oil prices during the first six months of 2017 was matched by a lesser drop in the value of equities in the energy sector. By the end of June, Brent crude oil prices had fallen by nearly 20%, while the sector eventually declined by 62% of that, or 12%. The subsequent rebound in prices was not matched by a commensurate rally in shares, however. By the end of the year, Brent oil had gained over 50% (and has continued to rise in 2018), while the MSCI World IMI Energy index (which includes large, mid, and small-cap stocks) had advanced by less than 20%.
Understanding the reasons for energy sector underperformance
If the beta, or correlation coefficient between the two, had remained at 62%, the sector would have ended up the year nearly 16% higher instead of just 4%. Instead of 62%, though, the ratio has been just 36%, that is to say, the correlation was greater when oil prices were falling than when they were rising (see Exhibit 2). Understanding the reasons for the energy sector’s underperformance may give us some perspective on its outlook for 2018.
Exhibit 2: Oil price and energy sector returns in 2017
Note: Indexes rebased to 100 as at 31 December 2016. Oil price refers to Brent crude. ‘Energy sector’ is the MSCI World Energy IMI index. Returns in USD. Source: FactSet, BNP Paribas Asset Management, as of 05/01/2018
One clue as to why the rebound in oil prices was not matched by a commensurate gain in equity prices is the future value of oil priced in by the market. At the beginning of 2017, the futures curve had a positive slope, that is, oil prices were expected to be higher at the end of the year by about USD 2 per barrel. Even as oil prices reached their 2017 low in June, the expected price one year out was more than USD 3/bbl higher. Currently, the future price is more than USD 4/bbl lower, a condition known as backwardation (or an inverted or negatively sloped curve). The inverted curve for oil prices suggests markets are not expecting to be surprised again (perhaps inevitably).
The reasons for the inversion stem from market expectations for oil supply and demand. To take demand first, one surprise in 2017 was that both China and continental Europe achieved higher-than-expected economic growth. This led to higher oil demand, which pushed up prices. However, we expect Chinese GDP growth to slow in 2018 and what growth there is to be driven less by energy-intensive industrial sectors than by energy-light services sectors. While European growth should remain robust (by recent standards), we do not expect it to accelerate meaningfully. Currently extreme temperatures in the US and Australia have added to short-term fuel demand, but this should not persist.
Oil price outlook: pluses and minuses
Some of the factors affecting supply should be supporting prices, while others might weaken them. Support should come from declining US crude oil inventories: they have fallen to their lowest since 2015, although they are still high compared to the long-run average. Markets have been surprised by OPEC’s ability to maintain the quotas limiting production. Investors had understandably been sceptical given the past failure of such agreements, but perhaps the prospect of rising US shale oil production forced other producers to be more disciplined.
US shale oil is, in fact, the factor perhaps weighing the most on prices. US shale oil producers are very price-sensitive and unlike with wells in conventional oil fields, they can turn production on and off relatively easily. The number of rigs used in the production of US oil and gas moves closely in line with the price of oil (see Exhibit 3). Note how the more recent surge in oil prices has not been matched by an increase in the rig count, which can be seen as another indicator that oil prices are not expected to remain at their current levels.
Exhibit 3: US oil and gas rotary rig count and West Texas Intermediate (WTI) oil prices
Note: Returns in USD. Source: Baker Hughes, Bloomberg, BNP Paribas Asset Management, as of 05/01/2018
With oil prices now comfortably at above USD 50/bbl, we expect US production to continue to rise modestly, putting downward pressure on oil prices. The reduction in regulations limiting oil exploration in Alaska and off the coasts of the US is likely to increase production in the medium to long term. The balance then between shorter-term factors increasing demand and medium-term factors pushing up supply explains why the oil futures curve is negatively sloped and hence why energy sector shares have not benefited proportionately from the rise in oil prices: investors simply believe the good times will not last.
Some energy sector segments look more promising
Despite this rather more cautious outlook for oil prices, might energy sector stocks nonetheless be an attractive investment? As always, it depends on price relative to the earnings outlook. The expectation that oil prices will decline over the next year is reflected in analyst forecasts of limited earnings growth for the integrated oil & gas sector. Expansion of the shale industry, however, means the forecasts for energy equipment & services stocks, as well as those in exploration & production (E&P), are much brighter (see Exhibit 4).
Exhibit 4: Earnings forecasts (next 12 months)
Note: MSCI World IMI Energy indices. Estimates in USD. Source: FactSet, BNP Paribas Asset Management, as of 05/01/2018
Deeply cyclical sectors can show excessively high P/E ratios when prices are temporarily depressed. This is indeed to some the degree the case with energy, where even when taking prices compared to earnings expectations in 18 months, multiples are high relative to long-run averages (see Exhibit 5).
Exhibit 5: Forward P/E ratios for S&P 500 indices
Note: Estimate is forward 18-months. Source: IBES, BNP Paribas Asset Management, as of 08/01/2018
On a price-to-book basis, multiples look more attractive, at least for the integrated oil & gas sector (1.8x currently vs. a long-run average of 2.5x) and for equipment & services (1.9x currently vs. a 3.3x average). Exploration & production, however, is still priced at above average, at 2.3x book value of assets today compared to an average since 1999 of 1.6x.
Further energy sector underperformance in the pipeline
It is likely that the energy sector will again underperform the broad market in 2018. We expect oil prices to weaken over the course of the year, although not dramatically as there is still firm underlying demand thanks to robust global growth. The expansion in shale and off-shore drilling in the US, though, should drive above-trend growth in the equipment & services and the exploration & production segments. That opportunity may already be reflected, however, in valuations. As to the integrated oil companies, while they are not necessarily “running on empty”, they are low on fuel and there is still quite some way to go until the next filling station.