Oil Price Rally: Time to Go All-In on Energy Stocks?

Rising oil prices are definitely back. After cratering at less than $30 a barrel just two years ago, the price of benchmark West Texas Intermediate crude has since more than doubled to around $71 a barrel.

While that may be a concern for anyone planning a summer road trip—nationwide, the average price of regular unleaded gas has risen by about 20 cents in just the last month¹—many stock market observers are wondering how far prices might rise—and whether they’ll drag oil-linked stocks with them. Indeed, the S&P 500 Energy Index has delivered a total return of about 7% so far this year. That’s slower than the 18% rise in the WTI price this year, but it beats the 2.5% return on the broader S&P 500® Index.

So are oil prices going to keep rising? And if they do, will oil stocks follow? Would it make sense for the tactically minded investor to consider adding more oil stocks to their portfolios?

Not necessarily.

“We believe the potential is there for oil and the energy sector to move higher over the next several months,” says Brad Sorensen, managing director of market and sector analysis for the Schwab Center for Financial Research. “However, the risks of a sharp reversal are substantial enough that most investors would be better served by keeping their exposures to the 11 different sectors of the S&P 500 Index within a reasonable range—say, a few percentage points—of the sector’s weighting in the index. For energy, that would be about 5% of their stock portfolios.”

“Investors willing to face some potentially higher risk could consider a slightly larger allocation, but they should be prepared for some potentially stomach-churning moves,” he says.

Let’s take a closer look.

Reasons for the rise

There’s a lot happening in the world of hydrocarbons, some of it recent, some of it longer-term. Here are the big reasons oil prices have been rising:

The return of sanctions on Iran. President Donald Trump’s recent decision to back out of an agreement aimed at curbing Iran’s nuclear capabilities has opened the way for a return of sanctions that could limit Iran’s oil production. While no details have been released and it’s not clear whether the remaining parties to the nuclear deal—including major European countries and China—will curb their purchases of Iranian oil, Iran is still a major producer and any disruption could still filter through to global prices.

OPEC and Russian production cuts. Concerned about the plunge in prices in 2016, members of the Organization of Petroleum Exporting Countries (OPEC) and Russia agreed to scale back production in the hopes of reducing global supply. Despite a history of struggling to honor such voluntary cuts, the parties have actually stuck to their agreement over the past year and a half, resulting in production cuts of about 1.8 million barrels per day and helping to drive prices higher. Of course, it’s possible that additional curbs on production by OPEC-member Iran could cause the cartel to declare their mission accomplished and start pumping again, but that remains to be seen.

Venezuela’s woes. A variety of problems and years of underinvestment in the oil industry have conspired to drive OPEC-member Venezuela’s output down about 40% over the last two years, according S&P Global Platts, and it’s possible the United States could impose additional sanctions on Venezuela’s oil industry in response to concerns about an upcoming presidential election in the South American country. Venezuela is one of the world’s major producers and has long been one of the largest suppliers of oil to the United States. That said, it’s possible that slumping production in Venezuela has also helped OPEC meet its targets for cutting production and a further drop in output could cause other OPEC members to re-open the spigots.

Growing global demand. All these crimps in supply come as the International Energy Agency expects global demand for oil to grow by 1.5 million barrels per day to 99.3 million barrels this year. And with the International Monetary Fund projecting global economic growth to be 3.9% in both 2018 and 2019, that would seem to support increasing demand for energy.

Some caveats

If the future seems to favor a further increase in prices, does it necessarily make an unequivocal case for stocks to follow suit? That’s a tough one.

“If the price of oil continues to rise, which is the consensus forecast, it seems likely to us that the energy sector will continue to outperform,” Brad says. “However, we remain reluctant to encourage investors to jump in with both feet because of the simple fact that oil prices have historically been prone to sudden plunges just when they’ve seemed to be gearing up for further rises.”

For example, if OPEC decided to end its production cuts in the face of rising prices, that could halt the rise. Saudi Arabia, in particular, has spare capacity that it could bring online. And the U.S. oil industry has shown a remarkable ability to rapidly dial up production when the price is right. In fact, the rig count has been rising steadily after bottoming out in 2016, according to data from Baker Hughes.

“I also think it’s telling that energy stocks have been lagging the gains in oil—stock investors remain a bit skeptical that oil producer discipline can remain,” Brad says. “And it’s possible some of the bullishness is already priced in, with Ned Davis Research showing that hedge fund bets against energy, as measured by their short positions, are at multi-year lows, while Oil.com is reporting that the hedge fund ratio of long positions to short is 15-1—the most lopsided in their history.”

If sentiment were to cool and the rise in U.S. rig counts to slow, that might merit a larger exposure to the sector, but for now Brad is sticking with the index weighting.

¹AAA data as 5/11/2018.