Thursday, December 1, 2022
The S&P 500 Energy Sector and West Texas Intermediate (WTI) crude oil have meaningfully decoupled over the last several months. The divergence in performance started over the summer and became more pronounced near the end of September when WTI dropped to year-to-date (YTD) lows. Since then, oil has struggled to catch a sustainable bid, while the energy sector has rallied toward multi-year highs. The dichotomy between declining oil prices and the rising energy sector has left many investors questioning how the deviation developed and perhaps most importantly, how might it get resolved. Cutting to the chase, history suggests the performance gap could narrow from a potential rebound in crude oil, while the energy sector may see further gains.
Uncertainty over China’s economic reopening has been one of the primary catalysts behind crude oil’s underperformance. China’s strict ‘zero-COVID’ policy has dampened demand expectations from the world’s largest oil importer. The recent surge in COVID-19 cases has further complicated the outlook for reopening as new lockdowns are enforced across the country, although there have been some signs of easing restrictions over the last few days.
As the demand outlook from China became clouded, Russian oil output ramped up last month ahead of European Union import bans set to kick in on December 5. According to Bloomberg, Russian oil production jumped to an eight-month high in November. The uptick in near-term supply coupled with a weakening global demand outlook put downward pressure on front-month WTI futures. Longer-term WTI futures contracts managed to dodge some of the recent selling pressure, suggesting the bearish supply and demand backdrop could be a shorter-term issue for oil. For example, WTI futures contracts expiring in May and June of 2023 have held up above their September lows and witnessed shallower drawdowns compared to front-month futures.
At the sector level, improving fundamentals have helped offset weaker oil prices. Over the last several years, energy companies have shifted away from spending on production to returning cash to shareholders. As shown in the chart below, the free cash flow yield (trailing 12-month free cash flow per share divided by price) for the sector is now near 11.0%, more than quadrupling over the last two years alone. At the same time, the sector’s blended forward 12-month price-to-earnings multiple is only at 9.7x. Attractive valuations underpinned by earnings growth have been another major counterbalance to oil price volatility.
While these factors help explain how energy stocks and oil prices decoupled over the last few months, they do not explain how the divergence could end. In an effort to answer this important question, we analyzed historical periods to identify when the energy sector has significantly outperformed crude oil. The methodology to our analysis is outlined below.
- Calculate the rolling 90-day rate of change (ROC) for the S&P 500 Energy Sector.
- Calculate the rolling 90-day ROC for WTI crude oil futures.
- Create an index based on the difference between the ROC for the energy sector and crude oil (ROC differential index).
- Apply a +2 standard deviation band to the ROC differential index.
- Identify crossovers (signals) when the ROC differential index crosses above the +2 standard deviation band.
- Calculate forward returns for the energy sector and crude oil after each signal.
The bottom panel of the chart below highlights recent signals generated over the last year, including the most recent crossover signal on October 19.
When applying the model to data going back to 1990, we found 46 filtered trade signals (applied a minimum 20 trading day separation between each signal). The returns for the energy sector, WTI crude oil, and the S&P 500 are highlighted in the table below.
In summary, we found crude oil historically outperforms with positive returns after significant divergences from the energy sector. In addition, meaningful energy sector outperformance over crude oil does not imply the sector will necessarily turn lower. As shown above, the energy sector has still produced positive forward returns across each period and outperformed the S&P 500 during this timeframe.
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