The oil markets remain highly volatile, but continue to have little forward momentum, with WTI prices resuming their negative trading to move away from the pivotal $71.55 resistance level, pointing to renewed expectations of declines in the upcoming sessions.
According to Standard Chartered, the extreme volatility being witnessed in the oil markets is due to gamma hedging effects, with banks selling oil to manage their side of options as prices fall through the strike prices of oil producers put options and volatility increases.
The negative price effect has been exacerbated because the main cliff-face of producer puts currently occupies a narrow price range. While gamma hedging effects do not trigger the initial price fall, they result in a short-term undershoot, further magnified by the closing out of associated less committed speculative longs.
But the bulls are not ready to move to the sidelines, yet.
According to Wall Street investment bank Goldman Sachs, there’s still a path to $100 oil with the oil permabull predicting a supply crunch will help turn the markets around. Goldman’s global head of commodities research Jeff Currie has predicted that oil prices could climb back above $100 a barrel in the current year.
“Are we going to run out of spare production capacity? Potentially by 2024, you start to have a serious problem.’’
Last month, GS advised investors to buy energy and mining stocks, saying the two sectors are positioned to benefit from economic growth in China. GS’ commodities strategist has forecast that Brent and WTI crude oil will climb 23% and trade near $100 and $95 per barrel over the next 12 trading months, an outlook that supports their upside view for profits in the energy sector. "Energy trades at a discounted valuation and remains our preferred cyclical overweight. We also recommend investors own mining stocks, which are levered to China growth through rising metals prices," the investment bank stated in a note to clients.
There are several reasons why the energy sector could still outperform later in the year despite underperforming in the year-to-date. Here are some.
#1. Cheap Valuations
Last year, the energy sector turned on the afterburners and managed to top all sectors as the global energy crisis exacerbated by Russia’s war in Ukraine triggered a big oil price rally. The sector has been more subdued in the current year with investors once again flocking to Big Tech and semiconductors. But the surprising finding is that energy stocks remain real cheap, both by absolute and historical standards.
Indeed, the energy sector is the cheapest of all 11 U.S. market sectors, with a current PE ratio of 5.7. In comparison, the next cheapest sector is Basic Materials with a PE valuation of 11.3 while Financials is third cheapest at a PE value of 12.4 . For some perspective, the S&P 500 average PE ratio currently sits at 22.2. So, we can see that oil and gas stocks remain dirt cheap even after last year’s massive runup, thanks in large part to years of underperformance.
Rosenberg has analyzed PE ratios by energy stocks by looking at historical data since 1990 and found that, on average, the sector ranks in just its 27th percentile historically. In contrast, the S&P 500 sits in its 71st percentile despite last year’s deep selloff.
#2. Market Deficit
Oil prices have only been treading water since the big initial gains from the shock announcement, with concerns regarding global demand and recession risks continuing to weigh down the oil markets. Indeed, oil prices barely budged even after EIA data has shown that U.S. crude stockpiles have been falling while Saudi Arabia will hike its official selling prices for all oil sales to Asian customers starting May.
But StanChart has predicted that the OPEC+ cuts will eventually eliminate the surplus that had built up in the global oil markets. According to the analysts, a large oil surplus started building in late 2022 and spilled over into the first quarter of the current year. The analysts estimate that current oil inventories are 200 million barrels higher than at the start of 2022 and a good 268 million barrels higher than the June 2022 minimum.
However, they are now optimistic that the build over the past two quarters will be gone by November if cuts are maintained all year. In a slightly less bullish scenario, the same will be achieved by the end of the year if the current cuts are reversed around October.
#3. Healthy Earnings
Although earnings for the energy sector are expected to come in lower relative to 2022 earnings, the sector is still expected to perform relatively well. According to FactSet data, the blended net profit margin for the S&P 500 for Q1 2023 is 11.5%, which is above the previous quarter’s net profit margin of 11.3%; above the 5-year average of 11.4%, but below the year-ago net profit margin of 12.2%. At the sector level, only three sectors are reporting (or have reported) a year-over-year increase in their net profit margins in Q1 2023 compared to Q1 2022, led by Energy (to 12.4% vs. 10.4%) and Consumer Discretionary (6.6% vs. 4.7%) sectors.
With more than 90% of S&P 500 companies having returned their quarterly scorecards, the Energy sector (+7.9%) has reported the fourth-largest positive (aggregate) difference between actual earnings and estimated earnings. Within this sector, EQT Corporation ($1.70 vs. $1.30), Coterra Energy ($0.87 vs. $0.70), Williams Companies ($0.56 vs. $0.47), and Phillips 66 ($4.21 vs. $3.56) reported the largest positive EPS surprises.
Overall, there are 11,038 ratings on stocks in the S&P 500. Of these 11,038 ratings, 54.2% are Buy ratings, 39.9% are Hold ratings, and 5.8% are Sell ratings. At the sector level, the Energy (63%) and Communication Services (61%) sectors have the highest percentages of Buy ratings, while the Consumer Staples (45%) sector has the lowest percentage of Buy ratings.
By Alex Kimani for Oilprice.com