Recession fears pose challenge to energy shares after stellar year

© Reuters. FILE PHOTO: A U.S. flag is seen outside the New York Stock Exchange (NYSE) in New York City, U.S., January 26, 2023. REUTERS/Andrew Kelly

By Lewis Krauskopf

NEW YORK (Reuters) -A potential U.S. recession and tough comparisons to a stellar 2022 are weighing on the prospects of energy stocks delivering an encore to last year’s stunning run, despite valuations that are seen as still comparatively cheap.

The S&P 500 energy sector is up 4.2% year-to-date, slightly lagging the rise for the broader index. The sector logged a 59% jump in 2022, an otherwise brutal year for stocks that saw the S&P 500 drop 19.4%.

Energy bulls argue the sector’s valuations bolster the case for a third-straight year of gains, which would be the first such feat for the group since 2013. Goldman Sachs (NYSE:GS), RBC (TSX:RY) Capital Markets and UBS Global Wealth Management are among the Wall Street firms recommending energy stocks.

Despite last year's run, the sector trades at a 10 times forward price-to-earnings ratio, compared to 17 times for the broad market, and many of its stocks offer robust dividend yields. The potential returns for shareholders were highlighted this week when Chevron (NYSE:CVX) shares rose almost 5% after announcing plans to buy $75 billion worth of its stock.

Some investors worry, however, that energy companies may find it hard to increase profits after huge jumps in 2022, especially if a widely expected U.S. economic downturn hits commodity prices.

"The group appears to be holding up well, but there is some trepidation due to the fact that investors are concerned about an economic slowdown and what that will do to demand," said Robert Pavlik, senior portfolio manager at Dakota Wealth.

He said he is slightly overweight the energy sector, including shares of Chevron and Pioneer Natural Resources (NYSE:PXD).

Economists and analysts in a Reuters survey forecast U.S. crude would average $84.84 per barrel in 2023, compared to an average price of $94.33 last year, citing expectations of global economic weakness. U.S. crude prices recently stood at around $80 per barrel.

At the same time, many investors beefed up their holdings of energy stocks in 2022 after years of avoiding the sector, which had often underperformed the broader market amid concerns such as poor capital allocation by companies and uncertainties over the future of fossil fuel. The sector’s weight in the S&P 500 roughly doubled last year to 5.2%.

However, that dynamic may be petering out, said Aaron Dunn, co-head of the value equity team at Eaton (NYSE:ETN) Vance.

"People have come back to energy in a big way," he said. "We had that tailwind the last couple of years, which was that everyone was under-invested in energy. I don’t think that’s the case anymore."

And while energy companies are expected to deliver strong quarterly reports over the coming weeks after a roaring 2022, those numbers may have set a high bar for this year.

With 30% of the sector's 23 companies reported so far, energy's fourth-quarter earnings are expected to have climbed 60% from a year earlier, and 155% for full-year 2022, according to Refintiv IBES. But earnings are expected to decline 15% this year, the biggest drop among the 11 S&P 500 sectors.

Exxon Mobil (NYSE:XOM) and ConocoPhillips (NYSE:COP) are among the reports due next week, when investors also will focus on the Federal Reserve's latest policy meeting.

“Last year was a banner year," said Matthew Miskin, co-chief investment strategist at John Hancock Investment Management. "Now they have got to try to beat that to show growth, and I think that is going to be a challenge.”

In the meantime, bullish investors point to shareholder-friendly uses of cash by the companies.

The energy sector's 3.43% dividend yield as of year-end 2022 was nearly twice the level of the index overall, according to Howard Silverblatt, senior index analyst at S&P Dow Jones Indices. Energy companies executed $22 billion in share buybacks in the third quarter, just over 10% of all S&P 500 buybacks.

“From a total return perspective, that is where I think energy can still continue to differentiate itself versus the broader market,” said Noah Barrett, energy and utilities sector research lead at Janus Henderson Investors.

Others, however, believe more value may exist in areas of the market that were beaten down last year. Dunn, of Eaton Vance, said stocks in areas such as consumer discretionary and industrials may appear more attractive.

"Energy probably does OK this year, but I think you have got a lot of areas in the market that have done extremely poorly where we’re finding excellent opportunity,” he said.