Here are 5 reasons why energy stocks look like a buy despite rising 74% in a year

While focus this summer briefly shifted to a rebound in shares of information technology, consumer discretionary and other “growth”-oriented sectors, energy now appears to be back on a path (see chart) higher.

Buchbinder said this dynamic should continue, despite energy stocks being a “controversial investment for some,” in emailed comments Thursday. He also hasn’t been alone in his bullish call, with JP Morgan Chase & Co.’s equity research department and others on Wall Street calling out energy’s potential upside.

Here are five reasons why LPL thinks energy stocks are a “buy.”

Improving outlook

Sector fundamentals tell a compelling story. China’s economy has been reopening from this year’s COVID-19 lockdowns, while droughts have hampered production of hydroelectric power.

What’s more, positive signs of a potential accord to allow Iranian crude to flow freely again on the international market could be offset by production cuts from Saudi Arabia. As trader weighed the potential for an Iran deal, West Texas Intermediate crude for October delivery
CL.1,
-0.10%
 fell $2.37, or 2.5%, Thursday to settle at $92.52 a barrel on the New York Mercantile Exchange.

Technicals also look better

LPL’s Buchbinder pointed to several technical factors that could bode well for energy stocks. First, the sector remains in a long-term uptrend, as it has been trading just 10% shy of its all-time high in June. Breadth also has been strong, with more than 90% of stocks in the S&P 500 energy sector trading at 20-day highs, as of Aug. 23.

Finally, should the energy sector return to outperforming the rest of the S&P 500 by the same degree it did during the first half of the year, this would translate to 20 percentage points of relative outperformance, he said.

Strong earnings momentum

Energy was the clear winner of the second-quarter earnings season. Not only did energy generate the most earnings growth, it’s still on track to lead the S&P 500 in earnings for the year, according to Buchbinder. The sector also saw the most upward earnings revisions to 2023 earnings expectations.

Strong earnings have increasingly supported share repurchases and dividends.

Valuations reflect pessimism

To be sure, one reason energy stocks tend to trade at lower valuations is because nobody can say for sure where oil and natural-gas prices are headed.

But if one assumes that prices will be stable, or higher, in the next several quarters, then the valuation of energy stocks looks pretty compelling, Buchbinder said.

The sector has been trading at a price-to-earnings ratio below 9 based on 12-month forward earnings. That’s compared with 17.5 for the broader S&P 500.

Buchbinder said that doesn’t make sense, given the strong cash flow yields for the sector, which are topping 10%, more than double the level for the S&P 500.

Warren Buffett

Berkshire Hathaway, the conglomerate run by Warren Buffett, a week ago received permission from the Federal Energy Regulatory Commission to increase its stake in Occidental Petroleum Corp
OXY,
-1.25%
up to 50%. The firm already owns more than 20%, after an aggressive buying streak.

“We’re not saying buy OXY, but rather that if Mr. Buffett likes the energy sector that much, we should pay attention,”

The S&P 500 energy sector includes more than 20 companies, including Exxon and Chevron, but also exploration companies like Devon Energy Corp.
DVN,
-1.29%
and Halliburton
HAL,
-2.42%,
which focuses on selling equipment to companies engaged in hydraulic fracturing, or “fracking.”

Investors can gain exposure to the sector by buying individual stocks, or by purchasing a sector-tracking exchange-traded fund like the Energy Select Sector SPDR Fund
XLE,
-1.17%.

The energy sector lagged the S&P 500
SPX,
-3.37%
on Thursday, with a 0.8% gain compared with the 1.4% advance for the broader index.

Prices of WTI were up 36% in the past 12 months. Natural gas
NGU22,
+0.26%
for September delivery rose to $9.375 per million British thermal units Thursday, adding to its roughly 140% climb in the past 12 months, including as Russia’s invasion of Ukraine has thrust the European Union into an energy crisis.

Read: This is what would happen if Russia cuts off the gas supply to Europe entirely, according to Morgan Stanley