Energy stocks (represented by the S&P 500’s Energy subindex) rose in the six months ending November 20, 2022, despite a massive drop in crude oil prices. Although the two price series are highly correlated, it is not exceptionally rare to see them move in opposite directions. It has happened in 28% of the six-month comparisons since September 1989. The size of the recent divergence was extremely unusual, though.
As detailed in the table below, the percentage price changes for the latest six months were +5.5% for Energy stocks and -29.8% for the West Texas Intermediate (WTI) crude oil contract. The 35.3-percentage-point edge for Energy stocks is the sixth largest out of 393 six-month comparisons. Aside from a 37.9-percentage-point advantage recorded in the six months ending October 2022, no gap as great as the latest one has occurred since July 1997. This time around, moreover, Energy stocks’ rise overcame a substantially larger crude price decline than in the 1990s cases.
The May 31-November 30 divergence between the prices of Energy stocks and crude oil contrasted with their close linkage in 2022’s first five months. Over that interval, they posted gains of +55.7% and +52.5%, respectively. The two price series have historically shown an 89% correlation on a monthly basis.
Energy stocks did not achieve their recent price gain in the face of a drastically declining crude oil price by riding the coattails of a broad rally in stocks. Between May 31 and November 30, the S&P 500’s price change measured -1.3%. Year-to-date, Energy has walloped the all-industry index, +64.2% to -14.4%.
The Energy sector has also handsomely outperformed this year in the high-yield bond market. Its -10.6% year-to-date price return is far better than the ICE BofA US High Yield Index’s -15.9%. For the six months ending November 30, the respective price returns were -4.3% and -6.6%.
Explaining the Decoupling
An important factor in WTI’s sharp rise earlier this year was a supply constraint triggered by the Russian-Ukrainian war. That shortage was partly alleviated by the US Administration’s decision to draw on the Strategic Petroleum Reserve. Also contributing to the crude price decline from its peak was an expectation of reduced global demand due to an economic slowdown in China. So why did Energy stocks continue to climb in the face of these developments?
Ordinarily, a likely explanation for this sort of divergence is an expectation that the crude price will soon reverse course and return to its previous highs. That is not applicable in the present case, however. The futures market for crude is currently in backwardation, meaning that the future price is lower than the current (“spot”) price.
Changes in the institutional and regulatory environment may be contributing to Energy stock prices’ relative strength. Over the last several years, the public policy emphasis on developing renewable fuel sources has discouraged investment in fossil fuel exploration and development. The federal government has not deemphasized the push for green energy. Still, surging gasoline prices earlier this year focused attention on the reality that the US economy remains heavily dependent on fossil fuels during the transition to renewables. The prospect of stepped-up investment in conventional fuels implies higher long-run earnings growth for the Energy group.
RATIO BETWEEN S&P ENERGY SUBINDEX P/E and S&P500 INDEX P/E (Bloomberg)
Valuation can also help to explain Energy’s strong year-to-date relative performance. The median ratio between the Energy subindex’s price-earnings multiple and the S&P 500’s from January 31, 1990, to the present is 0.87x. At the end of 2021, the ratio stood at just 0.54x, making Energy stocks relatively cheap. Even after WTI soared to its 2022 month-end peak in May, the Energy subindex’s multiple was still below its historical median ratio to the S&P 500’s, at 0.75x.
Can Energy Continue to Outperform?
The valuation story supports the case for Energy continuing to outperform. On November 30, the ratio of its multiple to the S&P 500’s was just 0.47x, well below the 0.86x historical median. Ordinarily, the sector’s prospects for the next few quarters would depend heavily on the direction and magnitude of crude oil price changes.
However, attempting to predict those factors seems especially difficult, given the huge swings this year. Over the near term, though, it may not matter. Energy stock prices and WTI have recently decoupled to a degree not witnessed in decades. This is unlikely to last.