Hype surrounds AI, but old school energy is back

Coiled spring if conditions change

There is an emerging trend in both Canada and the United States worth highlighting: the return of the energy sector as a top performer.

After a brief hiatus, energy stocks are once again screening positively as an area that warrants investors’ attention, even if our views toward the broader headline indexes remain far from constructive.

So, what is driving this assessment? The reasons boil down to one simple observation: the sector is among the most unloved in both countries, ranking at or near the bottom in terms of positioning metrics we track. As a result, concerns of overvaluation that are front and centre for the broader market are not present in the energy sector.

For example, in Canada, our valuation subcomponent in Strategizer ranks at a 40th percentile reading historically and at a 28th percentile relative to the S&P/TSX composite index. For the U.S., the comparable figures are at a 55th percentile reading historically and 11th, respectively. While these developments alone do not call for immediate gains ahead — cheap stocks can be cheap for a reason — they do act as a coiled spring in the event that market conditions change.

It does not take much to move fund flows back into the sector when such pessimism is rampant among investors, especially over a longer-term horizon. That these companies have evolved their capital discipline over the years, offering higher dividends and buybacks as a result, also means investors are paid to wait with all-in yields (dividends plus buybacks) of 5.2 per cent in Canada and 6.8 per cent in the U.S., which compare to 3.5 per cent and 2.9 per cent for the S&P/TSX composite and S&P 500, respectively, more broadly.

To illustrate how much investors have ignored this part of the market, we can look at Bloomberg fund flow data in the U.S. to visualize how overlooked energy stocks have been. Over the past year, there has been US$2.7 billion in net outflows from the SPDR Energy Sector Fund ETF — ranking dead last among the 11 SPDR sector funds. On the other end, US$5 billion in net inflows went into the Technology Select Sector SPDR Fund. In the context of the artificial intelligence/ tech-led mania that began early last year, this makes complete sense. Energy companies just aren’t as sexy as semiconductors.

Let’s explore what could cause a reversal on this front.

First, bubble-like conditions have driven market concentration, sentiment and valuations for tech (and related) stocks to extreme heights. And while the AI cycle is real and will have tangible benefits, what is conveniently forgotten is that the electricity needed to run the data centres behind all this computing power is significant. This should provide a higher floor underneath global demand than may historically have been the case despite a squishy-soft global economic backdrop.

Second, and partly related to the first point above, the winds are shifting back toward fossil fuels given the recent struggles in the “E” part of ESG (environment, social and governance). We have long said that while the energy transition to a cleaner future is a real theme, the reality is that we still need cheap sources of energy to help bridge the gap and meet growing demand while the transition takes place. For example, Shell PLC recently scaled back its carbon-reduction plans to help become more competitive given this reality. Moreover, this theme was front and centre during the recent CERAWEEK conference hosted by S&P Global Inc. in Houston.

Third, on the supply side, the Organization of Petroleum Exporting Countries and its allies (OPEC+) have committed to reducing output until the end of the second quarter at a time when geopolitical events are impacting supply in the Middle East and Russia (Ukraine appears to have shifted its strategy to targeting Russian refineries of late).

THE ELECTRICITY NEEDED TO RUN THE DATA CENTRES IS SIGNIFICANT.

Fourth, a Donald Trump victory could usher in a wave of deregulation similar to what transpired following his first term in 2016. Joe Biden has made it clear through various moratoriums and regulations that he is campaigning on a “clean” energy future, and it is safe to believe that Trump would be energy-sector positive. How OPEC+ responds to more U.S. supply would be a wild card to the underlying commodity price, however.

Ultimately, after being left for dead, it will not take much to cause a shift in energy stocks in the other direction as a result, and the select list above represents potential catalysts that may spark such a rotation.

Energy has been outperforming the other sectors in the U.S. to little fanfare since early February (it is No. 2 in Canada over this time), displaying positive momentum during this period and may be a sign that money is starting to flow back into the sector.

For those seeking to diversify away from the bubble-like tech/ai trade, the signal from energy stocks in Canada and the U.S. shows this sector to be a serious contender on this front.

Marius Jongstra is a vice-president of market strategy at independent research firm Rosenberg Research & Associates Inc., founded by David Rosenberg. To receive more of David Rosenberg’s insights and analysis, you can sign up for a complimentary, one-month trial on the Rosenberg Research website.