Energy sector stocks: Is now the time to invest?

Energy stocks, in recent weeks, retreated from a solid 2024 start. Oil prices moved higher to start the year, but declined in the summer months. As a result, investors cooled on the energy sector. Year-to-date through July, the S&P 500 Energy sector gained 13.3%, lagging the broad S&P 500 Index by roughly 3%. In August, energy stocks suffered a modest decline, but fell significantly in September’s first half. As of mid-September, the S&P 500 Energy sector, year-to-date, gained 3.91% compared to 18.74% for the S&P 500.¹

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.

In 2023, oil prices were flat to lower, and energy stocks followed suit. Oil prices moved above $80/barrel by mid-March 2024 and stayed near that level until dropping below $80/barrel in May. Oil prices held between $70 and $80/barrel for much of 2024’s summer months but dipped below $70/barrel in September.² As oil prices fell, natural gas and heating oil prices continued to decline as well. Prices for all key energy products remain significantly lower than 2022 peaks.²

All prices published by U.S. Energy Information Administration. Crude Oil price per barrel: West Texas Intermediate (WTI) – Cushing, Oklahoma as of Sep. 9, 2024. Gasoline price per gallon: U.S. Regular All Formulations as of Sep. 9 2024. Natural Gas price per million BTU: Henry Hub Natural Gas Spot Price as of Sep. 10, 2024. Heating Oil price per gallon: No. 2 Heating Oil Prices: New York Harbor as of Sep. 9, 2024.

Energy supplies were temporarily threatened by a decision from Oil Petroleum Exporting Countries+ (OPEC+) to trim production levels. OPEC+ initiated the change in 2023 in an effort to force oil prices higher. However, increased U.S. oil production helped make up any supply shortfall. The U.S. is more insulated from oil supply challenges as it has moved from a net importer to net exporter of oil.³

While supply fluctuated, demand growth subsided, due in large part to major users like China and Japan experiencing slower economic growth. “Now OPEC+ countries may be interested in boosting production, but if they do so, they will likely have to accept lower market prices,” says Rob Haworth, senior investment strategy director at U.S. Bank Wealth Management. “The key for drilling companies is that the cost of production remains lower than crude oil’s market price. That’s key to making the business profitable.”

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 just 3.5% 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.⁴

While energy stock performance is often linked to the direction of oil prices, Haworth points out that is less true of oil refiners and storage and transportation company earnings. Haworth also notes that about one-third of the S&P 500’s energy sector is composed of natural gas companies, a market where pricing generally moves independent of oil price trends.

A gradually transitioning 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. Fossil fuels and nuclear combined make up 75% of all energy production in the U.S., while just less than 25% comes from renewable sources (including wind, solar and hydroelectric power). However, renewables as an energy source are slowly gaining market share.⁵

On a worldwide basis, renewables now represent 30% of all electricity production.⁶ “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.” Haworth notes that given distinct policy preferences of the major political parties, the election outcome may well influence the near-term expansion of renewable energy generation.

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 second quarter, EVs accounted for only 8% of U.S. new car sales, though that is up from 7.2% a year earlier.⁷ However, EVs are experiencing faster growth abroad and worldwide by 2030, are projected to account for 40% of passenger and commercial light-duty vehicle sales.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. 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.