What's Powering the Energy Sector's Performance?

By Paul Franzen, CFA®, Senior Equity Analyst
October 26, 2022

The energy sector’s 2022 returns to date clearly stand out in comparison to the other sectors of the S&P 500 Index. What do you believe has contributed to this performance?

What's Powering the Energy Sector's Performance?
While high volatility and overall market declines have been hallmarks of the S&P 500 Index for much of 2022, energy stocks have been a consistent bright spot. The energy sector has delivered positive returns of nearly 35% as of Sept. 30, 2022. In stark contrast, the overall index is down about 24% year-to-date (YTD).1 From our perspective, one of the biggest drivers to this outsized performance in relation to the other 10 sectors in the S&P 500 has been rising commodity prices. In the U.S., the average price per barrel of oil this year is 45% higher than 2021, while prices for natural gas have increased nearly 80% on average over the same period.

So, what’s going on with commodity prices? We believe there are three key factors behind this surge in prices:
1. U.S. producers are more disciplined with production today than in prior cycles, which also allows for generally higher prices. In addition, there has been a general underinvestment in supply from large energy companies globally, which results in a classic supply vs. demand struggle whenever we see demand pick up.
2. Russia’s invasion of Ukraine and subsequent decline in the flow of natural gas imports to Europe from Russia via pipelines. Notably,  recent sabotage to the largest pipeline from Russia to Europe now renders supply from that previously important pipeline useless for the foreseeable future. Furthermore, additional sanctions on Russian energy set to take place in December could further impact Russian supply.
3. OPEC has spent much of the year unwinding its previous supply cuts, which now leaves the world with less spare production capacity and adds to the geopolitical risk premium for oil. Then in October, OPEC announced its largest supply cut since the beginning of the pandemic signaling its willingness to defend oil prices that had begun to fall on concerns of slowing global growth.

Given the energy sector’s solid performance this year, are there any areas of concern for investors?

We believe there are a couple of areas worth noting. Despite the hot start to the year for both the sector stocks and commodities, we’ve seeing a cooling off recently with both the sector and oil. Gas prices also have declined over 25% off their highs of the year. The energy pullback has primarily been driven by reduced expectations for energy demand as concerns over the Federal Reserve aggressively tightening financial conditions, a strong U.S. dollar and inflationary impacts all weigh on the outlook for demand growth.

Energy Sector YTD Returns

However, while slowing economic growth is a headwind to energy demand expectations, the underlying supply deficit story is likely to reemerge whenever overall economic growth picks back up, eventually leading to upward pressure on commodity prices for oil and gas once again.

Russia’s war with Ukraine shined a spotlight on the eurozone’s dependence on Russian energy. Is there a path forward for Europe to avoid a prolonged energy crisis and if so, what is it?

Europe finds itself in the unfortunate position of having no easy answers or quick fixes to their present energy crisis. Positively, Europe has made good progress on refilling natural gas storage levels ahead of the high-demand winter heating season. However, those storage levels are likely to only provide Europe with roughly half of their natural gas needs this winter. Thus, Europe is likely to remain reliant on Russia and global liquefied natural gas (LNG) for the foreseeable future to satisfy its demand for natural gas.
Oil and Natural Gas Price Change YTD
With recent sabotage to the largest natural gas pipeline from Russia to Europe rendering supply from that previously important pipeline useless for the foreseeable future, and LNG prices at multiples as high as 9x as of September 30, 2022, Europe’s use of natural gas this winter will be very expensive. Governments will likely be forced to absorb a large portion of the near-term economic pain as they look to provide economic support to their citizens in a variety of ways while also helping bail out those utilities that are limited in their ability to fully pass on the spike in commodity prices. Conservation plans are also actively being pushed to help reduce demand.

These factors of high costs and calls to reduce demand will weigh heavily on the European economy in the coming months. Longer-term, Europe will need to push to further diversify and grow its sources of energy supply to extricate itself from its current predicament, an effort we believe will take more than just one winter.

Is the spike in European natural gas prices impacting the U.S.?
Yes, the price increases of global natural gas are impacting U.S. natural gas prices. Natural gas commodity returns are up 81% YTD. Historically, the U.S. was an island unto itself when it came to natural gas. However, the U.S. has quickly grown into the largest exporter of natural gas, now exporting over 10% of all the natural gas we produce. The amount of natural gas we export — primarily as LNG — is likely to continue to grow. We expect this increase in demand will increasingly tie U.S. natural gas prices to those of the global market.

As a result, the U.S. price of natural gas in 2022 has reached its highest level in over a decade. While this is likely to result in higher winter heating bills in the U.S. this year, the spike in prices for many eurozone countries will be far more dramatic. We believe some U.S. LNG shippers and natural gas producers will likely benefit from this trend.

The recently passed Inflation Reduction Act is designed to significantly reduce U.S. greenhouse gas emissions by 2030. How does this bode for both traditional fossil-fuel stocks and renewables?
A primary goal of the Inflation Reduction Act (the Act) is to reduce U.S. greenhouse gas emissions by 40% by 2030. To help achieve this, the legislation commits approximately $390 billion over the next 10 year in spending and credits related to energy and climate change. There are many incentives for clean fuels like hydrogen, extended solar power credits, new battery storage tax credits, and tax credits for buying qualified Electric Vehicles, among other things. We are likely to see increased investments across the energy, alternative energy, industrial and utilities sectors to capitalize upon the incentives from this comprehensive legislation.

As the U.S. works to grow our renewable energy capacity, traditional forms of energy will continue to remain important for many years in terms of both energy security and relative price stability. A primary lesson we can learn from the European energy crisis is the importance of energy diversity. We believe the Act should allow for a reasonable mix of both traditional and renewable forms of energy in the coming years.

1 Commerce Trust, “Market Tracker,” September 2022. https://www.commercetrustcompany.com/news-and-insights/2022/september-market-tracker
The Chartered Financial Analyst® (CFA®) Charter is a designation granted by CFA Institute to individuals who have satisfied certain requirements, including completion of the CFA Program and required years of acceptable work experience. Registered marks are the property of CFA Institute.
Past performance is no guarantee of future results, and the opinions and other information in the commentary are as of October 24, 2022. This summary is intended to provide general information only and is reflective of the opinions of Commerce Trust. This material is not a recommendation of any particular security, is not based on any particular financial situation or need and is not intended to replace the advice of a qualified attorney, tax advisor or investment professional.
Diversification does not guarantee a profit or protect against all risk. Commerce Trust does not provide tax advice or legal advice to customers. Consult a tax specialist regarding tax implications related to any product and specific financial situation. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.
Commerce Trust is a division of Commerce Bank.
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ABOUT THE AUTHOR

paul franzen commerce trust company
Paul Franzen, CFA® Vice President, Senior Equity Analyst Commerce Trust Company 
Paul is a senior equity analyst for Commerce Trust Company. He covers the energy, financial services, utilities, and real estate sectors while providing stock recommendations for the company’s Fundamental Process and routinely communicates investment messages to portfolio managers.

Paul was also a panelist speaker for the American Gas Association and a three-time winner of Forbes “Best Brokerage Analysts” distinction.

He earned his bachelor’s degree in finance from Kansas State University in 1999, graduating cum laude and holds the Chartered Financial Analyst® designation. Paul also is a member of the CFA Institute and the CFA Society of Kansas City. In his spare time, Paul spends as much free time as possible with family. He also enjoys reading and various outdoors activities including golfing, running, and lake life. Paul and his wife, Sasha, have two young children who love to ride bikes, explore trails and museums, and play at the pool.