We’re about halfway through 2021, and many readers may be surprised to learn that Energy is the top S&P 500 sector performer year-to-date. The Energy sector has registered a greater than +30% return for the year (as I write), which is more than double the gains of the broader S&P 500 index.1
Is Energy’s performance poised to last, and should investors add exposure?
I’m not so sure. For one, investors should note that Energy’s outperformance in 2021 is following years – even a decade – of underperformance. From the S&P 500 index pre-pandemic high through the bottom of the bear market in March 2020, the Energy sector fell more than -50%. Looking even longer-term, one would find that the global Energy sector has still not recaptured the highs reached in 2007.
There are several forces at work for the Energy sector. Over the past decade, the U.S. shale boom drove production and supply significantly higher, and the response globally was to add even more supply – putting downward pressure on prices and squeezing margins for U.S. shale producers. This supply glut, coupled with the ‘muddle through’ economic expansion following the Great Recession, negatively impacted the profit picture for many oil and gas producers, many of which were carrying high debt loads. Weak stock returns followed.
So, when considering the Energy sector’s strong bounce in 2021, I think it is important to see it as a product of a very weak base, with the sector in effect retracing losses versus reaching new all-time highs. Crude oil’s strong bounce over the past year (chart below), which was attributed to lockdowns giving way to re-openings, drove renewed interest in the sector. This initial surge in demand is likely to abate with time.
Source: Federal Reserve Bank of St. Louis2
Looking ahead, the Energy sector’s structural issues remain. For one, spare capacity in the U.S. and via OPEC+ producers remain high, meaning that new supply can come online quickly in response to a better profit picture. Indeed, higher crude prices have already spurred higher rig counts and oil well completions in the U.S., which has historically been a sign of increasing production. Assuming OPEC+ countries counter higher U.S. production by adding even more supply – as they have done in the past – the profit conundrum could surface again. Uncertainty abounds.
Finally, investors may also wonder what effect renewables could have on the Energy sector outlook. There are two factors to consider here. Renewables are indeed gaining market share in total energy consumption, mainly at the expense of coal. With electricity consumption, for instance, the share of renewable generation was 28% in Q1 2020 – a growing figure.3 But the second factor is the real kicker: many renewable energy companies (wind, solar, etc.) are not even in the Energy sector! Many ‘green energy’ companies are actually classified as Utilities. Their performance does not directly impact the performance of the Energy sector, since many are not even in the Energy sector to begin with.
Bottom Line for Investors
The Energy sector is off to a strong start in 2021, but at the end of the day, the sector’s overall contribution to the S&P 500 index has been shrinking over the past decade. As I write, the Energy sector makes up 2.8% of the S&P 500 index, down from over 10% before the 2008 financial crisis.4 At Zacks Investment Management, we actively shift portfolios as these types of weightings change.