Investors Still Underweight Energy

Marshall Adkins, expert energy analyst at Raymond James says that despite the tremendous outperformance of energy stocks in the past five years, the majority of investors are still underweight energy stocks.

Despite the impressive energy stock gains of recent years, today’s energy weighting is still lower than the 30-year average of 11.5%, by nearly 100 basis points, and this strongly suggests that investors are underweight energy relative to long-term historical averages. The reality, however, is that many investors have very short-term memories. Because ongoing sector rotation into energy stocks has doubled energy’s market cap weighting from 5.3% in 2002 to 10.6% currently, to many of these shorter-term investors energy stocks may well appear overweight relative to recent history. We clearly disagree with such a view. Given our thesis that long-term energy fundamentals are very bullish relative to the overall market, we are convinced that energy weightings will continue to move upward over the next five to 10 years.

Do earnings matter anymore?

From a fundamental perspective, a more appropriate measure of proper sector weightings should be sector earnings contributions. It used to be that earnings mattered and companies were valued on their ability to generate earnings and/or cash flows. Apparently, this does not seem to matter that much to today’s energy investors. As shown in the adjacent chart, the energy sector has accounted for 14.3% of the S&P 500’s earnings over the past decade (1998-2007) while capturing only 7.1% of the market weighting. In other words, energy stocks should have been valued twice as much as they have been in actuality if their market cap weighting were to match their earnings contribution. Alternatively, of course, perhaps the rest of the market should have been valued 50% lower, but that would not be nearly as pleasant.

The lowest point of the energy sector’s earnings contribution within the S&P came in 1998, a time when oil was averaging under $15/Bbl. When the price of oil went down, both in the early 1980s and in the late 1990s, investors readily discounted energy stocks, but as prices climbed, energy investors, once bitten, were much too shy to get on board. To also state the obvious: A reversion back to $15 oil, or even $40 oil, has long been highly unlikely, and it now seems utterly inconceivable given that OPEC is defending a price floor that we estimate is $60 at a minimum.

Even though energy stocks have performed extremely well over the past five years, the disparity between the energy sector’s market cap weighting and its earnings contribution has actually been widening. In 2002, for example, the weighting was 5.9% while the earnings contribution was 9.7%, a negative variance (or “underweight”) of 3.8%. With 2007 oil prices set to average at all-time highs, it is intuitive that energy’s earnings contribution has soared, and in fact it now stands at 21.7%. Also, while the market cap weighting has also increased, it is currently at only 10.6%, which means the market’s energy underweight has widened to 11.1% – nearly three times as wide as it was in 2002.

Why is there such a disparity between earnings contribution and market weighting?

The biggest reason we see behind this disconnect is that the market does not believe that $80+ oil is sustainable. As a secondary point, the market also does not seem to believe that natural gas prices, currently at relatively depressed levels, will eventually rebound. If oil prices plummet while gas continues to stagnate, then obviously future earnings come down and earnings growth turns negative. Under our commodity price assumptions, however, this scenario is extremely unlikely. For 2008, for example, we are projecting record $80.00/Bbl oil (up 18% year-over-year), followed by $85.00 oil (up 6%) in 2009. On the gas side, our $7.00/Mcf gas forecast for 2008 is flat y/y, but $8.50 for 2009 is up 22% y/y. We would note that current 12-month futures strips (~$87 oil and ~$7.50 gas) are considerably ahead of our forecasts. 

We would emphasize that energy sector earnings within the S&P are much more oil-levered (given that the mega-cap integrated energy companies are oil-focused) than the average E&P or oilservice stock we cover. To summarize, not only do we think that current energy earnings are sustainable, but earnings growth from energy companies should continue to outpace the rest of the market for the foreseeable future. The only fundamental difference we see with regard to 2008 and 2009 vs. the past few years is that energy earnings growth should be driven predominantly by oil rather than gas, at least for North American companies.

As a short term opposing view to this bullish outlook, is Ned Davis’ study that shows Energy typically underperforms the market after a second Fed rate cut. 

However, this relationship hasn’t worked out during this rate cutting cycle.  The Oil Services Index has actually outperformed the market in the 22 days since the last rate cut. 

Source: Stockcharts.com

I think this relative strength further bolsters the case that investors are still underweight the energy sector and are buying on any weakness. 

Contrahour does not own stocks mentioned in the post, although our clients do own other energy stocks.