Energy sector stocks: Is now the time to invest?

With oil prices up so far in 2024, energy stocks regained some momentum in recent months. This is contrasts with 2023, when S&P 500 energy stocks produced a narrowly negative return, while the broad S&P 500 gained more than 26%. Investors appear to see greater value in energy holdings this year. On a year-to-date basis through May 22, the energy sector gained 11.13%, nearly in line with the year-to-date 11.89% return for the S&P 500.¹ Energy stocks were off to a stronger start in 2024’s first four months when oil prices trended higher, but oil prices moved in the opposite direction in May, and energy stocks followed, retreating modestly.^{1 2}

How energy stocks respond to price trends

After energy prices peaked in 2022 amid a rapid demand surge as COVID-related shutdowns ended and supply constraints emerged tied to the onset of the Russia-Ukraine war, they’ve declined significantly since. Energy prices often tend to drive the direction of energy stocks. Energy sector performance soared in 2021 and 2022, a response to higher oil prices. But in 2023, oil prices were flat to lower, and energy stocks followed suit. Higher 2024 oil prices likely contributed to the initial boost for energy stocks, but prices for key energy products remain significantly lower than 2022 peaks.²

All prices published by U.S. Energy Information Administration. Crude Oil Prices: West Texas Intermediate (WTI) – Cushing, Oklahoma as of May 13, 2024. Gasoline: U.S. Regular All Formulations as of May 20, 2024. Natural Gas: Henry Hub Natural Gas Spot Price as of May 14, 2024. Heating Oil: No. 2 Heating Oil Prices: New York Harbor as of May 10, 2024.

While an improved supply-demand balance accounts for the dramatic price drop, “There’s still a tension in the market,” says Rob Haworth, senior investment strategy director at U.S. Bank Wealth Management. “U.S. oil production is fairly high, but OPEC-plus (Organization of Petroleum Exporting) countries are capping output.” Haworth says it’s an open question whether the potential for increased global demand will drive prices higher, or if OPEC boosts production to help meet the need.

How should investors view opportunities in this specialized segment of the market representing a critical part of the global economy?

Role of energy stocks

During the Arab oil embargo and various Middle East conflicts of the 1970s, the energy sector represented approximately 15% of the broader U.S. stock market. Today, it makes up slightly more than 4% of the S&P 500 index.¹ “Those numbers might suggest that it is an industry in decline, but energy consumption is up since the 1970s, and the important role energy plays in the broader economy is not diminished,” says Haworth. “From an earnings (profit) perspective, energy stocks play a more prominent role in today's S&P 500 than their index weighting would indicate.”

World oil consumption continues to trend higher with the notable exception of a decline in 2020 as world economies slowed due to the COVID-19 crisis.³

While energy stock performance is somewhat tied to the direction of oil prices, Haworth points out that oil refiners and storage and transportation company earnings are not directly tied to the direction of oil prices. Haworth also points out that about one-third of the S&P 500’s energy sector is composed of natural gas companies, a market where pricing generally moves independently from oil price trends.

The slow transition in the energy sector

Renewable energy sources, particularly wind and solar, are slowly gaining a foothold in world energy production, but the role of renewables today is dwarfed by other sources such as fossil fuels and nuclear, which combined makeup 75% of all energy production in the U.S., while about 25% comes from renewable sources (including wind, solar and hydroelectric power), little changed from a year prior.⁴

On a worldwide basis, renewables now represent 30% of all electricity production.⁵ “Alternatives like wind and solar are not a factor in the S&P 500 Energy Index to this point,” says Haworth. “In some cases, they may be represented in other sectors of the market, such as utilities or information technology.”

Efforts are also underway to reduce greenhouse gas emissions by converting fossil fuel-driven automobiles to electric vehicles (EVs), but it is a slow transition. In 2024’s first quarter, EVs accounted for only 7.2% of U.S. new car sales.⁶ However, EVs are experiencing faster growth abroad. More than 20% of cars sold worldwide in 2024 are expected to be electric.⁷

Recent trends put more pressure on oil stocks

Oil prices at 2024’s outset hovered near $70/barrel. Prices moved above $80/barrel by mid-March 2024 and stayed near that level until dropping below $80/barrel in May.² This occurred despite ongoing tensions in the Middle East stemming from the surprise Hamas attack on Israel in October 2023 and Israel’s response with military crackdown on the Gaza Strip. Concerns of a more widespread conflict persist but have yet to materialize. “We saw a modest spike in prices when Israel retaliated after the Hamas attack,” says Haworth. “However, oil production has not generally been affected by events in the Middle East.” In addition, the U.S. is more insulated from oil shocks as it has moved from a net importer to net exporter of oil.⁸

Investment considerations in today’s energy market

Investments in the energy sector today are primarily directed toward more traditional companies that participate in industries like oil and natural gas. While the price of resources such as oil and gas can have an impact on company results and stock performance, “the demand for fossil fuels is not going away in the near term,” says Haworth. “If global economies begin to recover, as may be happening in Europe and China, it could drive demand higher.” He emphasizes that opportunities are available even in a market featuring more stable prices. “Many exploration and production companies have productive oil wells and should be able to generate solid profit margins,” says Haworth. “Since these companies tend to return capital to shareholders in the form of dividend payouts, their stocks represent an opportunity for income-orientated investors.”

Other opportunities can be found in what’s referred to as the midstream energy sector, involved in the transportation of crude oil or refined petroleum products. “This sector is less dependent on energy prices than on the flow of oil, and volume moving through these facilities remains high,” says Haworth. Midstream companies tend to pay attractive dividends. However, the investment process can be more complex as it sometimes requires investments in limited partnerships. Partnerships issue K-1 forms to investors for tax reporting purposes, which can complicate an investor's tax filing process.

Alternative investments, such as renewables like wind and solar, are less visible in the investment markets. Utility companies emphasizing renewable energy sources offer one opportunity to pursue this part of the market. Some manufacturers of wind or solar equipment also offer opportunities, but they are far more limited than more established, traditional energy companies.

Energy stocks will play a modest role for those who invest in an index fund or ETF replicating the S&P 500 Index. Beyond that, consider consulting with your financial professional to determine whether more targeted investments in the energy sector can help you meet your long-term financial goals.