Oil prices have whipsawed over the last couple of years, but more recently crude futures (CLX23) have rallied to a series of new year-to-date highs. The performance of energy stocks is closely interwoven with oil and gas prices, as higher commodity prices boost their earnings – and by extension, their stock prices.

The recent price action of energy stocks has diverged from the broader equity markets. In 2022, the energy sector of the S&P 500 Index($SPX) gained 58%, and was the only sector to end in the green, as wider markets tanked and tech stocks had their worst year in decades. The energy sector, meanwhile, had its best-ever year in 2022 as Russia’s invasion of Ukraine helped catapult oil prices to multi-year highs.

However, the energy sector sagged in the first half of 2023, and was the worst-performing S&P 500 sector. Energy stocks stayed in the red, even as the artificial intelligence (AI)-fueled rally in tech stocks helped add over $4 trillion to the combined market cap of Nasdaq Composite ($NASX) constituents.

In recent months, though, as broader markets have come off their 2023 highs, energy stocks have rebounded. The S&P 500 Energy Sector SPDR ETF (XLE) has gained about 17% over the last three months.

Here are the risks and opportunities right now for investors looking to buy energy stocks after the recent rally.

These Factors Might Support the Rally in Oil Prices

Multiple factors could support the rally in oil prices. These include:

• Members of OPEC+ – which, until a few years back, were unwilling to lose market share – have now changed their strategy, and are quite amenable to cutting production to support oil prices, even at the cost of losing market share.
• Apart from the OPEC+ production cut, major oil producers like Russia and Saudi Arabia have extended voluntary production cuts to support prices.
• The International Energy Agency (IEA) has predicted a significant deficit in oil markets during the fourth quarter – which, in simple terms, means that demand will outstrip supply.
• The geopolitical situation is also supportive of oil prices, as the Russia-Ukraine conflict does not seem like it will be over anytime soon. Brokerages like Citi and RBC Capital Markets are now projecting oil prices to rise above $100 in the short term.

3 Big Risks for Energy Investors Right Now

That said, there are several risks that investors in energy stocks should be aware of, as oil prices face the following potential downside catalysts. 

1. A Slowing Global Economy

A slowing global economy is among the major risks for oil prices, as energy demand is interlinked with GDP growth. We have a structural slowdown in China, and the country’s stimulus to boost economic growth has not been to the scale that markets expected. U.S. economic growth has also been tepid, and the world's largest economy is expected to slow further – even as it may dodge the recession that many economists have been predicting.

2. U.S. Oil Production is Rising

While OPEC+ members have cut production, U.S. oil production is forecast to hit a record high in 2023. If energy prices stay strong, U.S. oil production might rise even more – which should help bring down prices.

On a related note, there is a thaw in U.S.-Iran relations, leading to hopes of a resumption of nuclear talks – which could eventually pave the way for more oil exports from Iran. While the country has major oil reserves, its production and exports have been hampered by sanctions over its nuclear program.

3. Central Banks are Not Yet Done with Rate Hikes

Central banks, including the U.S. Federal Reserve, might still not be done with rate hikes. Even as the tightening cycle is approaching its end, the pivot to rate cuts likely won't come in a hurry, based on persistently sticky inflation – and higher interest rates are invariably negative for commodities like oil.

Should You Buy Energy Stocks Now?

Energy stocks have already rallied in Q3 after a dismal first half, and some of the optimism over higher oil prices has been priced in. I see energy stocks as a hedge at this point. While any further increase in oil prices would help buoy energy stocks, it will also complicate the global fight against inflation, leading to more hawkishness from central banks - which will invariably be negative for the broader markets.

Overall, the risk-reward for energy stocks does not look very attractive at this point. While the valuations of energy stocks are still reasonable - and most are paying healthy dividends, with Chevron (CVX) offering a yield of 3.6% - the challenging macro environment could be a detriment for the sector.