Why energy stocks look cheap

Russ discusses why the energy sector still looks attractive, despite having struggled recently.

Following a stellar start to the year, energy companies have stumbled in recent weeks. Although the U.S. sector is still one of only four that is higher year-to-date, energy stocks have dropped more than 3% during the past month, in the process under-performing the broader market. Bellicose trade rhetoric has not helped, but the main culprit has been the prospect of higher OPEC production and an accompanying 10% drop in the price of crude. That said, while the sector is vulnerable to another big drop in oil, current prices suggest the stocks may be a bargain. Here’s why:

1. Value versus history

At two times trailing price-to-book (P/B) the sector looks cheap relative to its own history. Since 1995 the large cap S&P Energy Sector Index has traded at an average of approximately 2.4 P/B.

2. Value versus broader market

Energy stocks look even cheaper relative to the broader market. The sector currently trades at just 0.57 times the P/B of the S&P 500 (see Chart 1). This compares favorably to the long-term average of 0.82 and the post-crisis average of 0.76. This is one reason energy stocks are currently over-represented in value indexes.


3. Value versus fundamentals.

U.S. energy companies also appear cheap relative to two key fundamental factors: profitability and the price of oil. The fact that energy companies trade in line with crude should come as no surprise. Historically, investors have been willing to pay a premium, or at least a smaller discount, when the price of oil is high. Since 1995, this relationship has explained approximately 20% of the variation in the relative value of the energy sector. Today, with WTI crude at approximately $65 a barrel, the energy sector looks approximately 20% undervalued versus the broader market. A similar picture emerges when comparing current valuations to profitability. Measured by return-on-equity (ROE), profitability also explains about 20% of the variation in valuations. Based on this metric, energy companies appear about 10% too cheap.

Lower oil would take the sector down

What could change my view? The biggest risk is the most obvious one: oil prices. To state the completely obvious, energy stocks move with energy prices. Given the massive moves in crude oil in the post-crisis era, this relationship has been particularly strong. Since 2010, monthly changes in crude prices have explained approximately 50% of the variation in energy sector returns.

If OPEC’s resolve cracks or the global economy stumbles on the back of an escalating trade war, oil is vulnerable, and along with it the energy sector. While the risk is real, for now my assumption is that the global economy remains firm. Assuming that is correct, even if oil prices remain range-bound energy companies look like a bargain.

Russ Koesterich, CFA, is Portfolio Manager for BlackRock’s Global Allocation team and is a regular contributor to The Blog.

Investing involves risks, including possible loss of principal.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of June 2018 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader. Past performance is no guarantee of future results. Index performance is shown for illustrative purposes only. You cannot invest directly in an index.

©2018 BlackRock, Inc. All rights reserved. BLACKROCK is a registered trademark of BlackRock, Inc., or its subsidiaries in the United States and elsewhere. All other marks are the property of their respective owners.