Energy Stocks Come Roaring Back

It's no secret that much of Wall Street is adopting a green-is-good investing mentality to combat climate change. But that doesn't mean less environmentally friendly, old-style oil and gas stocks can't speed ahead from time to time. That's just what has happened in recent months.

Thanks to supply shortages and a rise in demand for fossil fuels as the economy recovers, large-company energy stocks have gained 60% since the start of 2021. That's more than double the 27% rise in the S&P 500 and tops all other market sectors. And it comes after a disastrous 2020, when energy stocks plunged 34% – the sector's worst return in a calendar year in more than a decade.

The resurgence of old-economy energy stocks comes as U.S. oil prices skyrocket. West Texas Intermediate crude prices recently hit their highest level since 2014 and topped $85 per barrel. And natural gas prices more than doubled in the first 10 months of 2021.

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In the past, these sharp price spikes have been bullish for energy stocks. Energy was the top-performing S&P 500 sector in 2007 and 2016, for instance, when WTI prices surged 58% and 45%, respectively, in those calendar years.

Many investment firms and the U.S. Energy Information Administration (EIA) are forecasting higher energy prices to persist in 2022, which bodes well for fossil fuel energy stocks, even as the world is focused on going green. We'll explain why and tell you the best way to make a strategic investment in this sector. Returns and data are through Nov. 5, unless otherwise noted.

A Suppy and Demand Mismatch

What's revving up fossil fuel prices?

For starters, bad weather and lower oil production have hurt supply. Hurricane Ida hobbled operations in the oil-rich Gulf of Mexico in late August, and snow and ice storms in early 2021 froze natural gas pipelines in Texas, which produces 25% of U.S. natural gas, the EIA says.

On top of that, OPEC, the 13-country oil cartel, has been slow to bring crude production back to pre-pandemic levels since its record cut in spring 2020 of 10 million barrels per day (roughly 10% of the global oil supply). Analysts say OPEC production won't recover to pre-COVID levels until mid-2022. Until then, scarcity should keep oil prices elevated.

The world's shift to clean energy and investors' growing preference for companies that score high on ESG (short for environmental, social and governance) measures are crimping supply, too.

Investors have pressured traditional energy companies to spend less on new oil wells and other fossil fuel projects and instead reinvest profits into buying back shares and paying bigger dividends. Oil and gas execs have been "beaten over the head by investors and ESG proponents who say, 'stop the development of fossil fuels,'" says Stewart Glickman, energy analyst at CFRA, a Wall Street research firm.

It's part of the reason why the number of active rigs drilling for oil and gas in the U.S. is down 50% from their recent peak level in late 2018, according to Baker Hughes, a company that provides oilfield services to drillers. The dearth of domestic energy production should exacerbate fossil fuel supply shortages in the coming months.

Meanwhile, demand is on the rise, thanks in part to the economic recovery. The International Energy Agency, a Paris-based organization that advises countries on energy policy, projects global oil demand to recover to pre-COVID levels by the end of 2022. Add that to short supply, and what you have is "a perfect storm" that supports higher energy prices, says Mark Haefele, chief investment officer of UBS Global Wealth Management.

A Bumpy Transition to a Net-Zero Economy

Clean energy isn't ready to take over from fossil fuels, and that's also good for oil and gas companies in the near term. Renewables currently lack the bandwidth to supply enough power when demand spikes. And clean energy is also vulnerable to weather. If the sun isn't shining or the wind isn't gusting or the rain isn't falling, the renewable-energy grid becomes less reliable and more vulnerable to intermittent outages.

What's more, the buildout of wind farms, solar infrastructure and renewable-energy storage solutions hasn't been big enough – so far – to make up for the reduced investment in fossil fuel projects.

"We lack the ability to count on renewables in the same way we can count on fossil fuels," says CFRA's Glickman. All told, these shortcomings lead to periodic energy price spikes that cause oil and gas stocks to rally.

Energy Stocks Have Plenty of Gas Left in the Tank

The long-term investing outlook favors green-friendly energy firms, but shares of oil and gas companies tend to perform well in periods, like now, when crude and natural gas prices are on the rise and demand is outstripping supply. Energy sector analysts at BofA say crude could top $100 a barrel this winter if temperatures plummet, a roughly 20% jump from current prices.

And profits are rising. In 2022, analysts expect 30.2% profit growth for energy firms year-over-year, outpacing the broad market's 7.5% increase, according to earnings tracker Refinitiv. In recent earnings calls with analysts, executives at oil services firms Halliburton (HAL) and Schlumberger (SLB) described the recovery in their businesses as a "multiyear" event.

Another plus: Energy stocks are cheap. The S&P 500 energy sector trades at 12.3 times estimated 2022 earnings, compared with a P/E of 21 for the broad market, according to S&P Dow Jones Indices. Will Riley, comanager of Guinness Atkinson Global Energy, says current prices of energy stocks don't fully reflect the earnings benefits that companies typically derive from the sharp run-up in crude and natural gas prices.

If you're thinking of adding fossil fuel companies to your portfolio, a tactical, diversified approach is best. To gain broad exposure to old-economy energy names, consider Energy Select Sector SPDR ETF (XLE, price $58, expense ratio 0.12%), which owns oil giants such as Exxon Mobil (XOM), as well as companies with gas and oil reserves, such as EOG Resources (EOG) and Pioneer Natural Resources (PXD), and oil services firm Schlumberger. Over the past 12 months, Energy Select Sector SPDR ETF has returned 106%.

The biggest beneficiaries of rising energy prices are the companies that "own the oil and gas under the ground and sell it when it comes to the surface," says CFRA's Glickman. That makes iShares U.S. Oil & Gas Exploration & Production ETF (IEO, $66, 0.42%) and First Trust Natural Gas ETF (FCG, $19, 0.61%) attractive now. Both funds track a broad index of shares in companies that generate the bulk of their revenues from oil and natural gas, such as ConocoPhillips (COP), EOG Resources and Occidental Petroleum (OXY). The iShares fund has gained 159% over the past 12 months; the First Trust Natural Gas ETF is up 214%.

And don't rule out fossil fuel com­panies that are taking meaningful steps to reduce harmful emissions. BofA highlights stocks with this kind of upside, including Chevron (CVX), Devon Energy (DVN) and ConocoPhillips.

Finally, we're not turning our backs on renewable energy. We view this area of the energy sector as a solid long-term, albeit volatile, investment. Consider SPDR Kensho Clean Power ETF (CNRG, $110, 0.45%) and Invesco WilderHill Clean Energy ETF (PBW, $92, 0.61%), which is a member of the Kiplinger ETF 20 list of our favorites.