By Michael Brush
Energy stocks are on fire — up 19% in September alone.
The move is so big, energy stocks are even attracting the endorsement of popular financial media commentators.
But don’t let that scare you.
Why would it? Normally when the popular media like a group, it is time to think about moving to the sidelines because the endorsement is a sign the crowd has arrived. Once everyone in a group likes a particular stock or sector, who is left to buy?
This time, however, it’s different. Those are some of the scariest words in investing, I know. But below are three reasons why, and 12 stocks to consider. At a high level, the bullish case has two parts.
Read: The S&P 500’s energy sector was the only port in a raging September storm for stocks
1. Energy stocks are up a lot in the past year, but they still are nowhere near pre-pandemic levels — while energy prices are back up there or much higher.
2. Organization of the Petroleum Exporting Countries (OPEC) and U.S. shale producers probably won’t rush to over-produce — the risk because it would knock down energy prices. Supply growth will be limited. Demand will remain strong.
Let’s take a closer look at the basics here.
Room to run
Energy stocks are really up a lot in the past year. It’s the kind of big move that makes you think it’s time to step aside. How big?
On Nov. 20, I predicted energy stocks would be 60% higher in a year. I was wrong. The eight oil stocks I suggested in that column were up 77% as of the Sept. 28 close. The three natural gas stocks were up 97%. That’s more than four times the 18%-23% gains for the Dow Jones Industrial Average /zigman2/quotes/210598065/realtime DJIA +1.26% and the S&P 500 /zigman2/quotes/210599714/realtime SPX +1.44% . My stocks also beat the five energy ETFs I mentioned in that column, which were up 57.4% as a group.
Despite this advance, there’s headroom for more gains. Consider the following.
1. The SPDR S&P Oil & Gas Exploration & Production ETF /zigman2/quotes/203527521/composite XOP +1.26% is still 46% below pre-Covid highs in October 2018. But the price of oil has returned to those levels. Natural gas is 30%-80% higher. And energy prices are probably destined to stay high.
2. Energy stocks are still arguably cheap. Stocks in the Guinness Atkinson Global Energy Fund /zigman2/quotes/208666626/realtime GAGEX +0.31% have a free cash flow yield (free cash flow divided by market cap) of around 9%-10%. That’s the highest level in the past decade, including 2014 when Brent oil was at $100 a barrel, says Will Riley, who helps manage the fund. (Free cash flow yield increases as stock prices decline.)
“We think energy equities discount oil price in the low $50s [per barrel],” says Riley. “If you believe, like we do, that a long-term price of $60 is appropriate, then there is upside,” he says.
Goldman Sachs this week raised its year-end oil price target to $90, citing the global demand recovery and tight supply. Riley is worth listening to because his fund beats its energy equity category by four percentage points, annualized, over the past five years, according to Morningstar.
Energy stocks have an enterprise-value-to-EBITDA ratio of around four compared to a pre-pandemic level of five to seven, says Benton Cook, who manages the Hennessy BP Energy Transition Fund /zigman2/quotes/207530769/realtime HNRIX +1.01% . “The valuation reflects a long-term oil price of $50 to $55,” says Cook, whose fund outperforms competing funds by 3.8 percentage points, annualized, over the past five years, says Morningstar.