Can Energy Stocks Power the S&P 500 to a New High?

Can Energy Stocks Power the S&P 500 to a New High?


Will this be the week that the Standard & Poor’s 500-stock index finally catches up with its blue-chip counterpart, the Dow Jones industrial average, to set a new nominal record? It has been less than weeks now since the Dow – a narrower index consisting of only 30 price-weighted stocks – accomplished the feat of topping the pre-crisis highs set in 2007. But for many market pros, the S&P 500 is a far more important indicator: It includes more stocks from a wide variety of industries, and is used as a benchmark by more investment managers. (Standard & Poor’s calculates that about $5.58 trillion in assets is measured against the performance of the index.)

The S&P 500’s current record of 1565.15 was set in October 2007; Friday it closed at 1560.70, less than five points away from breaking above that. (The index is ahead 9.4 percent so far this year, while the Dow is up about 10.8 percent.) If the index does break the record this week, it may be an unexpected rally on the part of energy stocks that finally does the trick.

That would be surprising, for several reasons. The ten largest stocks in the index account for about 20 percent of its weighting, but only two of them – ExxonMobil (NYSE: XOM) and Chevron (NYSE: CVX) – are energy companies, and together they represent just under 5 percent of the total index. Over the last five years, the annualized return of energy sector stocks in the S&P 500 has been almost zero. To be precise, investing in this group would have earned you a whopping 0.2 percent annually over the last five years.

What remains a little unclear at this point is whether something might be changing, making energy stocks more appealing in both absolute and relative terms than they have been in a while. ExxonMobil is now the largest company in the benchmark by market capitalization, thanks to the sharp selloff in Apple’s stock. Indeed, investors who had put money into the energy sector of the S&P at the beginning of the year would have earned 8.65 percent, more than double what they could have pocketed by allocating the money to the technology sector. So far this month, though, energy stocks are the only one of the ten sectors of the S&P to have failed to advance more than 1 percent.

What’s going on? For many months, a surge in natural gas production throughout the United States – thanks in large part to large new shale gas discoveries scattered around the country, from Pennsylvania to Montana and south to Texas and Oklahoma – has weighed on the commodity’s price and on corporate profits, even as these companies have been grappling with higher rates of capital spending. The result? Big gas producers like WPX Energy (NYSE: WPX) have seen their share prices fall: in WPX’s case, by 25 percent between mid-March of last year and the end of February of 2013. But so far this month, WPX has rebounded, climbing 18.7 percent, dwarfing the 3 percent gain of the S&P 500. The catalyst? A larger than expected decline in natural gas supplies for the week ended March 8, as reported by the Energy Information Administration yesterday. Natural gas prices soared 3.6 percent; WPX rose 5.2 percent Thursday on the news, and gained three cents more on Friday to close at $16.85 a share.

Should investors respond to this rally by becoming bullish not just on stocks, but on energy stocks in particular? Probably not. In fact, the signals suggest that this is a sector to remain wary of for some time to come. For starters, while total natural gas inventories, as reported last week by the EIA, now are 440 billion cubic feet below year-earlier levels at 1.938 trillion cubic feet, that’s still 198 cubic feet above the five-year average. That decline has been accomplished largely as a result of producers opting to shut in some of their reserves – in other words, to refrain from flooding the market with all the gas that they could be producing. A rally based on scarcity of supply or an increase in demand would be a far more convincing one.

Then you may want to consider that natural gas producers themselves – the same companies likely to lead the S&P 500’s charge above the 2007 record – are net sellers of their own assets at this point. One of the most aggressive companies trying to unload natural gas production assets is Chesapeake Energy (NYSE: CHK.) But WPX has also been doing this, including offloading $306 million of gas reserves to a group of private equity investors. Natural gas producers are unloved for a reason.

The longer-term picture, and even the medium-term outlook, may be more interesting, however. Natural gas is a cheaper and cleaner fuel than crude oil, and to the extent that the industry is able to build new pipelines and liquefied natural gas processing plants, it will be in a position to replace crude oil and coal in many applications. There also may be some upside potential for oil: While the International Energy Association sees demand growing a mere 0.9 percent this year amidst anemic global economic growth, the OECD raised some eyebrows by suggesting that prices could rise to anywhere between $150 and $270 a barrel by 2020, as demand from China, India and other emerging markets offsets even the growth in supply from unconventional sources, such as the shale formations. (Domestic crude oil currently trades at only about $93 per barrel; Brent crude prices are closer to $110, in contrast.)

The odds are, however, that the United States will become a major exporter of refined crude oil products and even of liquefied natural gas, once the infrastructure is in place. Don’t expect the country to become another OPEC, but the odds are that the best place to look for profits isn’t among exploration and production companies, but those who invest in and profit from that infrastructure, from companies building new pipelines to refineries. They’ll be less vulnerable to commodity price swings and shocks.

Even with that long-term potential, though, don’t get too energized about energy stocks just yet. Sometimes unloved and under-owned sectors represent value, but just as often they reflect reality.