U.S. energy stocks rebounded with a vengeance in 2016, with a handful of developments supporting strong enthusiasm for the industry. However, as with any instance of surging optimism, advisors would be well served to take a measured approach to investing in the sector. For 2016, the XLE Energy ETF generated an approximately 28% return, making it one of the best performing sectors within the S&P 500 Index. In doing so, it substantially outperformed the 9.54% return of the S&P.
Numerous developments during 2016 caused investment sentiment to quickly strengthen for the sector, which in past years has suffered from a substantial decline in oil prices. Since the middle of 2014, oil prices had dropped by more than 50%, with hydraulic fracking in U.S. shale reserves, the inability of OPEC to curtail output, and sluggish energy demands globally resulting in a glut of the commodity.
As oil prices plummeted, so too did the earnings of energy companies, which resulted in the drastic underperformance of the sector. In a similar manner, sluggish global economic growth has dampened demand for coal.
Yet the combination of low oil prices is causing some producers to curtail production and an autumn decision by OPEC to cut output has sparked a rally with West Texas Intermediate crude oil prices climbing 45% during 2016. It was the strongest oil rally since 2009 when WTI climbed 71%, according to CNBC.
Needless to say, the OPEC decision has supported enthusiasm that the oil rally will continue. Other factors are also at play. In the U.S., exuberance over the potential policies of Presidential-elect Donald Trump is providing a tailwind for energy stocks.
Trump is promising to reform regulations that some observers say are adding needless expenses to energy companies and prohibiting oil producers from investing in growth initiatives.
Trump has also said he doesn’t believe that climate change is driven by human activities, so he has pledged to reform or eliminate measures intended to slowdown the increase of carbon emissions.
Some observers maintain that Trump’s policies could therefore result in an end to subsidies for renewable energy and requirements that utilities increase their use of non-carbon energy sources. The change could result in increased demand for oil, coal, and natural gas as a response to declining use of alternative energy.
Trump’s plans to increase infrastructure spending while cutting personal and corporate taxes, meanwhile, could potentially rev up U.S. economic growth, which could increase demand for energy.
It’s important to note, however, that a potential prolonged energy sector rally could hit headwinds. For one thing, alternative energy, while still being a small percentage of overall energy, is becoming cost competitive with hydrocarbon commodities and may thrive even if subsidiaries are reduced.
Indeed, the recently released World Economic Forum paper “Renewable Infrastructure Investment Handbook: A Guide for Institutional Investors,” maintains that the cost of photovoltaic solar energy has been declining at a 20% compounded annual rate. Improvements in technology, meanwhile, are also expected to drive down the costs of wind energy.
In the U.S., furthermore, renewable energy standards have been gaining support from unlikely sources. For example, Ohio Republican Governor John Kasich recently vetoed legislation that would have frozen the state’s renewable energy standards. At the same time, some estimates say the investors with a total of $5 trillion in assets have pledged to divest from fossil fuel companies to fight global warming.
Investors should also note that non-OPEC producers can quickly increase oil production, which could lead to a softened market for the commodity. That is especially true when considering the hydraulic fracking can bring new wells online much more quickly than can traditional sources of oil.
At least in the U.S., an increase in production has already started, with American drillers having added rigs during each of the nine consecutive weeks leading up to the end of 2016.
While many investors are optimistic about economic growth accelerating, the potential scope of Trump’s fiscal stimulus remains unclear, so expectations that demand for hydrocarbon fuels may spike may be premature.
In Washington, budget hawks could curtail Trump’s proposed tax cuts and limit his plans for deficit spending on infrastructure projects.
Like with any periods of surging exuberance, taking a thoughtful approach to investing in the energy sectors may prove to be a wise strategy. Advisors may want to consider seeking out companies with strong fundamentals that are likely to grow their earnings throughout industry cycles rather than making large bets on the overall sector.