Can Energy Build on its 2021 Move?

The short answer is yes, yes it can.

Energy names were hit hard in 2020 as economies shut down in the wake of the coronavirus. The sector bounced back in 2021 when economies reopened. Energy rallied 39% in 2021 to outpace Real Estate (31%) and tech (29%) as the top performing sector.

Sector2021 Performance
Real Estate31.84%
Communication Services23.01%
Basic Materials12.03%
Consumer Cyclical10.92%
Consumer Defensive7.96%
Sector Performance

Perhaps the most interesting aspect about this rally is that it remains the second cheapest group in terms of forward earnings. Energy as a sector trades at approximately 8x forward earnings. Only Utilities is cheaper at 3x. Real Estate and tech, the other top performers, trade at a lofty 37x and 31x respectively.

SectorForward P/E
Real Estate37.99
Consumer Defensive23.34
Consumer Cyclical17.99
Communication Services17.26
Basic Materials15.22
Sector Forward P/E Ratio

Growth expectations for 2022 remain in place as evident by the Fed’s recent GDP forecast which it upgraded to 3.6-4.5% from 3.4-4.5% in its December meeting. This means the demand picture should remain in play.

The supply issues will also continue. Years of under investment due to political pressure from climate change initiatives make it difficult for countries and companies to ramp up production. The lack of supply was on display when the United States and allies announced the release of strategic reserves to fight against rising energy prices.

There is political pressure on OPEC+ to ramp up its production and alleviate pricing pressures. To wit, the group announced an increase of 400,000 barrels per day this morning. This was widely expected and will alleviate ease some duress, but it will not be enough to offset a strong inflationary and demand environment.

Omicron’s impact on supply chains and economies will raise short-term concerns around demand. Airlines are expected to report a big drop off in traffic due to the omicron spread. China with its ‘Zero Covid” policy will also be a drag on demand. This could lead to a pullback and a buying opportunity like what we saw when the emergency reserve release was announced in October.

OPEC already made headlines this week when it stated, “The impact… is expected to be mild and short-lived, as the world becomes better equipped to manage COVID-19 and its related challenges. This is in addition to a steady economic outlook in both the advanced and emerging economies”.

Early indications for 2022 reflect a continued rotation out of tech into energy to kick off the new year. However, energy is not a crowded trade.

A recent Bank of America Fund Manager survey noted allocation to energy declined 2% in early December. The current holdings by fund managers was only 0.1 standard deviation above the long-term average. This suggests plenty of room for investors to add given reasonable valuations and lack of a crowded field.

The SPDR Trust Energy ETF (XLE) is edging up toward the $58 resistance level and is prepared to breakout above that level. If we pan out to a monthly chart we see the stock is poised to test the $62-65 areas it traded in back in 2019, prior to the pandemic.

Given the economic environment and inflationary back drop we continue to see upside in the energy space and would view any pullback as a buying opportunity.