Calibrating the Energy Sector’s Potential Outperformance

It’s news to no one that energy has been the worst performing sector year to date with plenty of hatred of the sector to go around. Yet, as we write the price of WTI crude oil is up about 2% on news of capex cuts and OPEC’s apparent moves to reign in production and exports. Energy stocks are cooperating today as it is the best performing sector across the global developed markets (chart 1). Plenty of upside remains, however, at current oil prices and especially if prices move higher from here.

The next chart below shows the performance of the DM energy sector relative to the KLSU DM Index (blue line, left axis) plotted against Brent crude oil (red line, right axis). Over the last several months the relative performance of energy stocks has dramatically deviated from the price of the commodity, as shown by the blue line falling far under the level of the red line. In other words, energy stocks have underperformed by far more than the correlation with oil would suggest they should have. This provides an opportunity for investors.

In the next chart below we simply draw a scatter plot of the chart above. Here we plot the relative price level of energy stocks compared to the DM index against the price of Brent crude oil. We can see that the latest x,y coordinate is well below the level predicted by the trend model. A reversion to the trend line (read outperformance of energy by just enough to get it back to trend) would produce a 16% outperformance of the energy sector. If oil prices were to move to $60/bbl and the energy sector reverted back to its relative performance trend line, energy would outperform the broad market by 25%.