Create an Exit Plan for When Oil Stocks Run Out of Gas

The economy constantly cycles through sector winners and losers. The stock market obliges these trends with money flowing toward the shares of companies that earn outsize returns and out of the losers that are seeing their business falter.

During the pandemic, we’ve seen this dynamic in temporary winners such as Robinhood Markets (HOOD) , Coinbase Global (COIN) , Zoom Video Communications (ZM) and Moderna (MRNA) . At the same time, losers such as airlines and hotels were jettisoned.

There’s always a sense the good times won’t last for the winners, but timing is always tricky to predict, and who can argue with massive growth? The breathless reporting of Zoom’s earnings growth during the pandemic was way overdone but lasted many quarters.

There’s always a sector in the right place at the right time. Currently, the chosen sector is energy. Oil and gas companies are earning outsize returns with no end in sight after being a pandemic loser when oil traded negative and newly socially conscience funds divested such stocks.

Nobody knows the duration of the oil spike and how long the profits will keep rolling in for energy companies. There are forces at play, such as low inventories and the shunning of Russian oil, that have kept prices elevated. Nonetheless, having an exit plan is prudent when the good times are rolling.

It’s hard to watch financial television without finding pundits and money managers recommending the winner sector du jour. Pundits want to be associated with winning ideas and to find stocks that are working. Currently, energy has been an enormous winner in this bear market, and consequently, stocks in the industry are consistently touted on fin TV.

Understandably, pundits like recommending fundamentally sound ideas even if the stocks are already up huge. Often, this is just shorter-term thinking – merely finding the bull market for viewers without ever providing an exit plan.

World oil demand is expected to rise to a record of 101.6 million barrels a day in 2023, yet peak demand could be in site by 2025. In Bill Gates’ book “How to Avoid a Climate Disaster” he offers strategies and challenges to wean the world off fossil fuels.

For one, the book clarifies how dependent the world is on fossil fuels for most major industries. Indeed, one cannot understate the challenges, but the harmful effects of climate change and the elevated prices of fossil fuels will hasten investment in alternatives. The electrification of transportation is slowly underway, although other carbon-intensive industries necessary to manufacture electric vehicles, such as mining, offset some of the benefits.

Stocks are in a bear market, and oil stocks have made a quick correction with the recent market pullback. Granted, the energy stock pullback has occurred without the underlying oil commodity fading much. A few notable risks that can alter the outsize profits flowing to the energy sector include a strong price incentive to increase drilling activity and shift to alternative energy sources; recession-related demand destruction; or a breakthrough in Ukraine.

When in the middle of investing in a winning industry, recognize that history shows that these windfalls don’t last indefinitely. Energy prices can still surge higher on supply disruptions. Nonetheless, investors should have an exit plan to prepare for when energy prices settle back down and stock valuations contract.