Energy was the worst performing sector in 2018, but the sector found new life in the beginning of 2019, writes Lindsey Bell who will be speaking at the MoneyShow Orlando Feb. 7-10.
Energy was the worst performing S&P 500 sector in 2018, declining more than 20%, but the sector found new life in the beginning of 2019. A new agreement from OPEC and Russia to curtail oil production was key in relieving price pressure on the commodity, which, in turn, led to a swift move higher in energy stock prices. Up 10.2% year-to-date through Wednesday, Jan. 30, the energy sector is the second-best performing sector in the S&P 500 index, which is 7.0% higher in the same period. Upside momentum, based on its relative strength versus the S&P 500, has moderated over the past week and a half as West Texas Intermediate (WTI) oil prices stabilized between $51-$54 per barrel.
Just as key supply concerns diminished, global growth expectations were reduced by the International Monetary Fund (IMF) last week due to trade tensions and a slowdown in China. Thus, the uncertainty in the oil market has shifted from a supply side concern to a demand side question. To be sure, CFRA, the IMF and S&P Global Platts are not projecting a global recession in 2019, which means oil demand isn’t expected to fall off a cliff.
The largest risk to demand is China, with its future largely tied to the trade dispute with the U.S. In response to a slowdown in economic activity, the Chinese government has eased fiscal and monetary policy with additional measures to boost consumption announced this week. While commentary from corporations with exposure to the Chinese market have identified a slowdown in the region, economists expect the impact from stimulus to begin showing up in the economy by mid-year. In 2019, the IMF estimates GDP growth will decelerate to a still strong 6.2%, from 6.6% in 2018.
Ultimately, S&P Global Platts sees global oil demand growth settling at the long-term average growth rate of 1.5 million barrels per day in 2019, below the 1.7 million barrels per days growth estimated for 2018. Platts also forecasts WTI to average $58 per barrel in 2019, down from $65 per barrel in 2018. A recovery to $67 per barrel is expected in 2020.
With global demand returning to average growth rates, investors will likely keep a pulse on inventories in the U.S., which can have an impact on price. For the week ended Jan. 25, crude oil inventories increased 7% over the same period last year and are now 9% above the five-year average level of inventories. A similar trend can be seen in gasoline, where inventories are 6% higher year-over-year and 5% above their five-year average. That said, S&P Global Platts forecasts a decline in the supply in the U.S. as the year unfolds given plans by several shale operators to reduce drilling activity in 2019.
Globally, sanctions on Iran and Venezuela, as well as Saudi Arabia’s reduction, will also lead to a slowdown in supply in 2019. The only concern is uncertainty about Russia’s commitment to production cuts agreed to with OPEC as the country continued to increase production in December. Given the push and pull of supply-and-demand trends, it is easy to understand why prices are expected to average $58 a barrel this year, not far from the current WTI price.
More insights on the energy sector will come when heavyweights Exxon Mobil (XOM) and Chevron (CVX) report earnings on Friday morning. These two stocks account for 42% of the S&P 500 energy sector’s market capitalization.
MARKET OBSERVATION
Fourth quarter earnings expectations for the two integrated energy companies have followed oil’s price decline. Since the end of September, WTI spot oil prices have declined about 18.5%. Over the same period, Chevron’s fourth quarter consensus earnings per share estimate declined by 17.9%. For Exxon Mobil, the estimate declined by 18.7%. For the energy sector overall earnings estimates were reduced by 10.3% and estimates for the S&P 500 declined 5.1%. Earnings for the energy sector are highly correlated to WTI oil prices, with an R-squared of 0.9.
The more interesting pattern uncovered when analyzing the change in earnings expectations is that the consensus now forecasts an energy earnings recession to emerge in Q1 2019 through Q3 2019. Additionally, earnings growth for the sector in 2019 was sharply cut to a decline of 6.9% in 2019 from expectations of an increase of 25.8% on Sept. 30. We find this sharp reduction puzzling. The reduction (of 25% on a dollar basis) is significantly higher than the 16% reduction in the WTI oil price estimates by S&P Global Platts between Sept. 30 and now – from an average of $69 per barrel in 2019 to $58 per barrel. Given the expectation for demand, supply and oil prices to remain relatively steady over the next 12 months, we think earnings estimate reductions may have gotten ahead of themselves.
To be sure, there is always some level of uncertainty in the oil market, but as we think about 2019, we see risks to both the upside and downside with China at the top of both lists. The sharp move in earnings estimates have pushed valuations for the sector back to the historical average of 17.0x, which can be considered fair value. The S&P 500 energy sector’s 10% pop year-to-date makes it easy to forget that it was the hardest hit sector as the market corrected from a Sept. 20 peak, declining 23% into the end of 2018. In fact, even with the recent move, energy is still more than 19% off its 52-week high, further from the milestone than any other sector in the index. We look forward to receiving Chevron and Exxon Mobil’s earnings results and commentary about the outlook for the industry.
Please consider joining me at The MoneyShow in Orlando, FL from Feb. 7-10.
