Charts of the Week: Energy is not a Recovery Play

Many energy investors consider the group a “recovery play”, but history says the opposite. The sector typically lags the market when GDP growth accelerates (in the US or globally) and it lags even more when interest rates are falling. This slightly contradictory math to conventional wisdom happens because Energy most often zigs while the rest of the market zags. This time has been no different. Energy’s late 2022 peak profitability and returns happened when overall earnings growth was contracting by 10% (or was that one of the causes?). Fundamentals still look “solid” – ROE is top quartile, and capex/sales is bottom quartile – but that usually leads to underperformance, not the opposite.

Why? Because historically speaking, the rate of change is more important than the level for the relative performance of the stocks. The recent declines in profitability, and the increases in Capex (versus sales) have both been formidable headwinds for the sector, regardless of valuation. Starting points matter, and our current situation isn’t an advantageous one.

It’s also different this time. I analyze data from the 1960s, and two-thirds of those years have occurred during a secular decline in US Energy production. The mid-2010s shale driven production inflection is so steep compared to history that I should have shown it on a log scale. And even though rig count is much lower, and energy free cash flow is much higher, US production recently hit all-time highs - again. This illustrates just how productive current resources are.

If those efficiencies sound like good news for the stocks – they haven’t been. The bigger the production increase has been, the more likely the stocks lag the market. It doesn’t mean the price of oil falls – the commodity usually doesn’t. But it does usually mean the market has a lot more upside than the commodity itself. And this time may be no different.

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