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Our Take: Realities Behind the Equities Rally

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The oil and gas sector was king of equity markets in 2022, but we caution against taking too much direction from near-term performances. Investor responses to being severely underweight energy do not equate to a long-term endorsement of oil and gas, in our view, with transition risks to valuations and capital availability still in play as immediate energy security considerations ease.

  • Energy equities have answered the question of whether mainstream capital has forever abandoned oil and gas with a resounding “no.” The question arose as energy shares fell below 2% of the S&P 500’s market capitalization in 2020, as investors fled the abysmal returns of undisciplined US shale and claims of peak oil demand gained traction. But after a near 50% increase in market value last year, as the energy crisis buoyed prices and reminded investors of medium-term supply needs, energy once again comprises over 6% of the S&P 500’s market cap. By contrast, most sectors — and the wider market — were in the red in 2022.

  • Still, there is no room for complacency. Different investors work on different time horizons, and for all the momentum behind ESG issues, significant investor classes (particularly in the US) still operate outside the view that ESG is about financial risk and not just ethical investment. Instead, they have to meet or beat the market in returns performance, making it difficult to ignore oil and gas, for now.

  • Tapping the sector for a couple years of asset class-leading returns is not the same as rekindling a belief in the long-term prospects of unabated oil and gas. As one US fund manager put it, many investors are focusing on “milking the sector for cash” while the getting is good. It comes as little surprise that “capital discipline” has held so strongly in US shale; investor trust remains thin and firmly transactional.

  • Individual equities are also sending mixed messages about long-term strategic preferences. More conservative majors Exxon Mobil and Chevron readily outperformed their transition-embracing European peers, for example. But Occidental Petroleum, effectively an “all-in” bet on the viability of direct air capture, outshone small-, medium- and large-cap oil and gas alike.

  • Decarbonization demands haven't gone away. Calls for corporates to change have been complicated by the Ukraine conflict, with US firms in particular given breathing room to adopt less transformative strategies. But society’s arch still bends toward significant, and ever increasing, emission cuts. Sentiment shifts can come hard and fast, and it's inevitable more capital will ultimately exit fossil fuels as risks to asset valuations enter the time horizon of more investors. Investing to be transition-ready — a commitment that needs years to execute — isn’t about capturing a near-term valuation premium. It’s about downside protection as climate risk translates into more universal financial risk — and the vast re-rating that will follow.

Topics:
Equity and Debt Markets, Majors, ESG
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