IEZ - Will Energy Stocks Continue To Rise In 2023?

Summary

• Energy was the best performing S&P 500 sector in 2022 but crude prices have fallen sharply thanks to concerns about an economic slowdown.
• Despite near-term challenges, we remain constructive on energy stocks thanks to constraints on supply and attractive valuations.
• The iShares U.S. Energy ETF (IYE) and iShares U.S. Oil & Gas Exploration & Production ETF (IEO) offer investors a low-cost, tax-efficient way to invest in the global demand-supply imbalance we see persisting well into 2023.

Is the energy stock rally over?

Energy stocks were one of the few bright spots of 2022, an otherwise grim year for most investors. In fact, energy was the only sector in the S&P 500 to rally last year — climbing nearly 65% while the overall index fell over 19% — and was the largest contributor to S&P 500 earnings growth. ¹

But a new year brings new challenges, raising the question: Should investors stick with energy stocks in 2023?

The recent performance of energy stocks compared to energy commodities is a sign of the sector’s relative strength. Both the S&P Global 1200 Energy Index and S&P Energy Select Sector Index are trading less-than 4% below their respective 52-week highs, even as crude prices are down almost 35% from their 2022 peak. ²

Energy stocks vs. oil 2022: Equities outperformed the commodity

Source: BlackRock, Bloomberg. ‘Global energy’ represented by the S&P Global 1200 Energy Index, ‘U.S. energy’ represented by the Energy Select Sector Index. Rebased at 100 on January 03, 2022. As of January 05, 2023.

Index performance is for illustrative purposes only. Index performance does not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.

Chart description: Chart showing a 1-year comparison of the S&P Global 1200 Energy Index and S&P Energy Select Sector Index vs. crude oil, as represented by West Texas Intermediate ( WTI ).

But while we still see long-term opportunities, the near-term outlook for the energy complex is challenged by an unseasonably warm winter in Europe, and other headwinds, including:

• Global central banks remain committed to reducing inflation. Coordinated rate hikes in 2022 — and the potential for more in 2023 — have raised the risks of recession , which will likely crimp demand for energy and other commodities.
• Crude futures have fallen in anticipation of a slowing global economy (or outright contraction). Meanwhile, natural gas prices are down 65% from their August peak despite ongoing tensions between Russia and the European Union over natural gas supplies. ³
• Last year’s earnings boom makes tough year-over-year comparisons. Wall Street analysts expect the energy sector will be a drag on S&P 500 earnings this year, starting in the second quarter. In a reversal from 2022, where energy reigned as the largest contributor to earnings growth, the sector is now projected to be the largest drag. Year-over-year, the energy sector’s earnings growth is forecast to decline over 12%. ⁴

However, in the medium to longer term, we remain constructive on energy stocks given structural underinvestment in the sector and imbalanced supply-demand dynamics.

Energy stocks likely to benefit from limited supply, China reopening

Constraints on commodity supplies are likely to persist into 2023 and perhaps beyond; this bodes well for energy as discussed in our Mid Year Investor Guide . Supply chain bottlenecks, as measured by The New York Fed’s Global Supply Chain Pressure Index, fell considerably in 2022 but remain well above pre-pandemic levels and ticked higher in the fourth quarter. ⁵

China’s recent abandonment of their “zero-COVID” policy is another positive development for energy. Prior to the pandemic, China was the world’s third-largest consumer of liquified natural gas, second-largest oil consumer, and largest electricity consumer. Resumed manufacturing activity and overall energy use in China could help offset fears of recession-driven demand destruction.

The slower growth amid elevated inflation we anticipate well into 2023 could discourage companies from increasing production. In addition, energy companies have learned to emphasize capital discipline after the debt-fueled fracking boom and bust earlier this century, leading to underinvestment in the sector. Coupled with a relatively long capex cycle that ensures capacity constraints won’t be lifted immediately, we expect margins within the energy sector to remain robust. Energy stocks, meanwhile, remain attractive with price-to-earnings (P/E) valuations well below both the sector’s 10-year average and the S&P 500 overall.

Energy stock valuations vs. S&P 500

Source: BlackRock, Refinitiv Datastream. ‘Energy’ represented by the Energy Select Sector Index, ‘S&P 500’ represented by the S&P 500 Index. As of January 11, 2023.

Index performance is for illustrative purposes only. Index performance does not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.

Chart description: Bar chart showing a comparison of price-to-earnings ratios of the Energy Select Sector Index vs. the S&P 500.

The iShares U.S. Energy ETF ( IYE ) and iShares U.S. Oil & Gas Exploration & Production ETF ( IEO ) offer investors a low-cost, tax-efficient way to invest in the global demand-supply imbalance we see persisting well into 2023. The iShares Global Energy ETF ( IXC ) , meanwhile, offers investors exposure to global energy producers, which currently trade at a discount to their U.S. counterparts. ⁶

For investors looking to express a more bullish outlook on commodity prices, the iShares U.S. Oil Equipment & Services ETF ( IEZ ) seeks to track an index composed of stocks in the oil and gas equipment and services sector. Notably, FactSet predicts this industry group could post 46% year-over-year growth in earnings in 2023, despite the broader sector’s expected decline. ⁷

In sum, limited supply could offset falling demand to help keep commodity prices elevated. Combine this with the industry’s reluctance to aggressively increase production and we believe investors may continue to potentially benefit from owning energy companies in 2023.

¹ Source: S&P Dow Jones Indices – U.S. Sector Dashboard ( spglobal.com ).

² Source: BlackRock, Bloomberg. As of January 24, 2023.

³ Source: Bloomberg as of Jan. 13, 2023.

⁴ Source: Source: FactSet as of Dec. 9, 2022; the Energy sector is expected to report the largest (year-over-year) earnings decline of all eleven sectors in the S&P 500 at -12.4%.

⁵ Source: New York Fed as of Nov. 30, 2022 ( newyorkfed.org ).

⁶ Source: BlackRock as of Jan. 13, 2023. The iShares Global Energy ETF ( IXC ) trades at a price-to-book ratio of 2.18 vs. 2.93 for The iShares U.S. Energy ETF ( IYE )

⁷ Source: FactSet as of Dec. 9, 2022.

This post originally appeared on the iShares Market Insights.

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