Oil is Breaking Out and Energy Stocks Have Lots of Upside

As the famous Yogi Berra once said, “You can observe a lot just by watching”. At the moment we are watching the price of oil break out of a trading range to the highest level in about 2.5 years. The “common knowledge” explanation for the breakout is that leadership in Saudi Arabia is consolidating power and preparing the markets for a successful IPO of Saudi Aramco by keeping a lid on production. Or, there is the investment case we’ve been making all year (here, here, here and here), which is that energy capex has been slashed, oil finds are at generational lows, inventories are improving, and demand keeps ticking higher. Either way, if you like what you see in the oil markets, then you’ll love what you see among energy companies.

For example, even though the price of oil bottomed in early 2016 and now appears to be breaking above an important resistance level, energy stocks haven’t really played at all. The below chart shows our regression model of the energy sector’s relative performance and the price of Brent crude oil.  The current relative performance level of the energy sector is far below what the model would predict, about 20% lower to be exact. That is to say, for global energy stocks to get back to a trend level of performance given the price of oil, they would have to outperform by 20%.

Achieving 20% relative outperformance seems like a tough task, but we have to remember that energy stocks are as cheap as they get outside of a recession. The median DM energy stock is trading at just 1.8x book value and nowhere near peak valuations, contrary to the rest of the equity market.

What we are watching right now is the global energy market responding to a favorable fundamental backdrop and getting a major assist from a headline out of Saudi Arabia. The fundamentals for energy stocks are favorable too, and they could be poised for a serious bout of outperformance if these dynamics continue.