Friday, January 13, 2023
Energy outperformance has been a consistent theme over the last two years. The S&P 500 Energy sector posted respective annual price returns of 46.4% and 57.6% in 2021 and 2022, widely outperforming the broader U.S. equity market. One of the more surprising facts of last year’s return was that energy stocks rallied without much help from crude oil. West Texas Intermediate crude oil futures finished 2022 with a return of 6.7%, fading from intra-year gains of over 60% back in June.
While annual gains of this magnitude are relatively rare, LPL’s Strategic and Tactical Asset Allocation Committee (STAAC) believes the sector will continue to outperform and recommends an overweight to energy. Key macro catalysts include building demand growth from China’s reopening, a more conducive interest rate and dollar backdrop stemming from cooling inflation, and bullish supply-side dynamics. A further recovery in overall travel, including airline traffic, could be another significant driver for oil demand this year.
Broader energy sector valuations also look attractive. The S&P 500 Energy sector is trading at an estimated forward Enterprise Value (EV) to Earnings Before Interest, Tax, Depreciation, and Amortization (EBITDA) multiple of 5.8x for 2023, below its historical average of 7.9x. For reference, EV represents a company’s equity value or market capitalization plus its debt minus cash, while EBITDA provides an estimate of a company’s profitability from operations. The EV/EBITDA multiple is commonly used as an alternative valuation metric to the price-earnings (P/E) ratio. A lower EV/EBITDA multiple for energy points to the sector being undervalued based on historical comparisons.
Oilfield Services – Outperforming an Outperformer
The oilfield services (OFS) subindustry appears poised for further outperformance—over the energy sector and the broader U.S. equity market. Companies operating within this arena provide services and equipment for oil exploration, production, and transportation. Over the last few months, the OFS subindustry group has gone from an underperformer to outperformer within energy. The chart below highlights the performance of the Russell 3000 Energy sector and its major subindustry groups since the June 16, 2022 market low. Performance for the Russell 3000 index is also included for additional context.
Like the energy sector, the Russell 3000 Oilfield Services subindustry appears attractive based on its current valuation. As shown in the chart below, this group is trading at an estimated 2023 EV/EBITDA multiple of 8.4x, which is below its 10-year average of 10.7x and below its historical discount to the Russell 3000 EV/EBITDA multiple. In short, this implies that the Russell 3000 Oilfield Services subindustry is cheap relative to historical comparisons and the market.
Rising capital expenditures (CAPEX) across the energy sector and higher rig counts should continue to support the OFS space. Russia’s invasion of Ukraine last year made energy security a top priority, sparking an urgency for more diverse and reliable sources of oil and, ultimately, higher CAPEX for exploration and production companies, a tailwind for the OFS space. Furthermore, oil companies are adapting to the Energy Transition, a period generally characterized by a shift from using fewer fossil fuels to more renewable energy sources. As oil producers invest in the de-carbonization of oil and gas, OFS will benefit as they provide technology, services, and equipment for lowering emissions related to oil exploration and production. The chart below highlights the upward trend for oil rig counts and North American energy sector CAPEX.
Last but not least, the technical setup for the OFS subindustry remains bullish. As shown below, the Russell 3000 OFS subindustry has recently broken out from a bullish cup and handle formation, a pattern first recognized by famed investor and founder of the Investor’s Business Daily, William J. O’Neil. Momentum is also confirming the breakout, which generated a technical-based price objective near $540, or roughly 31% of upside from the January 12 close of $413.25. The bottom panel depicts the Russell 3000 OFS subindustry vs the Russell 3000 Energy index. The subindustry has recently reversed a downtrend and recaptured the 40-week moving average, implying OFS outperformance over the energy sector likely lies ahead.
In summary, the fundamental, macro, and technical stars align for the oilfield services subindustry to outperform the energy sector and broader U.S. equity market. Valuations appear cheap as macro conditions improve for both oil and the sector. Capital expenditures in energy are likely to be supported by increased demand for energy security and the transition toward the de-carbonization of fossil fuels. The bullish technical setup also implies more upside ahead.
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