As the price of crude oil tiptoes toward four-year highs, investors are throwing their caution aside and buying energy stocks. The good news: The rally looks like it has further to go.
In April, Canadian energy stocks in the S&P/TSX Composite Index rose 7 per cent. That’s by far the best one-month performance among the 11 industry groups in the benchmark index, which rose just 2 per cent over the same period.
Some of the more beaten-up names, which can provide turbo-charged leverage to the price of oil, have seen the biggest gains: Baytex Energy Corp. jumped nearly 65 per cent and MEG Energy Corp. rose about 50 per cent.
But even the behemoths are scoring impressive gains. Canadian Natural Resources Ltd. rose 14 per cent in April and Suncor Energy Inc. rose 10 per cent.
Rising oil prices can take most of the credit here. West Texas Intermediate crude (or WTI), the U.S. benchmark, has been approaching US$70 a barrel in recent trading. That’s more than double the price since early 2016, when oil prices were mired at 12-year lows.
The rebound is being driven by improving global economic growth, tighter energy inventories and discipline among producers in maintaining supply. The Organization of the Petroleum Exporting Countries, better known as OPEC, is reportedly keen to leave its current output unchanged, rather than open the spigot as prices rise.
But what’s particularly good for Canadian energy companies is the fact that the spread between WTI and Western Canadian Select (or WCS, the benchmark for oil produced in Alberta) is contracting. That is, WCS sold at a discount of about US$30 a barrel in February, but this discount has shrunk to nearly US$17, removing an obstacle that had been weighing on the results of Canadian producers.
Already, analysts are starting to factor higher oil prices into their expectations. Goldman Sachs expects that energy companies in the S&P 500 will increase their profits-per-share by a dazzling 110 per cent in 2018.
So far in the first-quarter reporting season, U.S. energy companies have reported a 66.5-per-cent improvement in their quarterly profits, over last year, according to Bloomberg News. That’s the best performance among 10 sectors in the index, and it’s twice the profit growth reported by technology companies.
According to Thomson Reuters I/B/E/S, profits among Canadian energy companies are also leading the way for the S&P/TSX Composite Index.
What does this mean for investors?
There’s a good chance that energy stocks will continue to outperform if the underlying global economy continues to hum and OPEC remains satisfied with its current output.
In a note on Tuesday, Goldman Sachs argued that the bullish case for commodities, including oil, has rarely been stronger.
“The weak returns of the past decade are behind us,” the analysts said in a note, quoted by Bloomberg News.
In mid-April, RBC Dominion Securities boosted its price forecast for WTI oil in 2018 by 17 per cent. RBC now sees oil averaging US$63 a barrel this year, up from a previous forecast of US$54. The analysts also raised their forecast for 2019, suggesting they believe the era of cheap oil is over.
“The global oil market has rebalanced itself ahead of our expectations,” RBC analysts said in a note.
Despite the impressive rally in Canadian energy stocks in April, the rebound began at a low level. The energy index is still 35-per-cent below its 2014 highs, when oil last traded above US$100 a barrel, and it is 15-per-cent below its 10-year average.
This suggests that there is potential for more gains ahead as investors grow comfortable with improving commodity prices.
Additional gains will no doubt help the broader S&P/TSX Composite Index, where energy stocks have a 20-per-cent weighting.
But the thing about rising oil prices is that they can weigh on profit margins outside the energy sector and divert money away from consumer spending, eroding the benefits to broad indexes.
Goldman Sachs estimates that for every US$10 increase in the average price of a barrel of oil, earnings per share for the S&P 500 − where the energy sector has just a 6-per-cent weighting − would rise a mere US$1 a share. That’s a pittance considering that the index produced total earnings of US$123 a share in 2017.
If you want to bet on oil, it pays to be specific. While that has hurt for the past four years, the outlook is starting to look a whole lot better.