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As oil prices skyrocket, energy sector stocks rally after disastrous 2020

Skyrocketing oil prices and a focus on discipline over growth have propelled energy stocks to the top of the S&P 500 so far this year.

The S&P 500's energy sector climbed 44.5% from the start of the year through June 11, compared to the 13.08% growth in the overall S&P 500. Over the same period in 2020, the S&P 500 dropped by about 7%, while the large-cap index's energy sector was down about 36.2%.

The rally has come as oil and gas companies have shifted their financial approach, favoring more conservative balance sheet management and debt repayment over supply growth.

"Growth is a much lower priority," said Rebecca Fitz, senior director of Boston Consulting Group's Center for Energy Impact, in an interview. "And I think that's the kind of structural change that makes these things stick that has more staying power than just the simple statement that we believe in capital discipline."

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As demand has recovered from pandemic lockdowns, oil prices have risen above $70 per barrel, after averaging near $40 per barrel in 2020.

"The oil market remains in the early innings of a strong cycle," said Michael Tran, managing director of global energy strategy at RBC, in a June 10 note.

Tran said prices for two benchmarks in the global oil trade — West Texas Intermediate and Brent — could reach $74 per barrel and $76.50 per barrel, respectively, in the second half of the year. On June 15, Brent was trading above $73 per barrel and WTI was trading near $72 per barrel.

The increase reflects global petroleum supplies returning to more "normal" levels this year after demand cratered last year, an ongoing tapering of OPEC spare capacity and the expected jump in U.S. shale production potentially into 2022, Tran said.

A June 8 forecast by the U.S. Energy Information Administration predicted Brent will average $65.19 per barrel in 2021, up from $41.69 per barrel in 2020, and WTI will average $61.85 per barrel in 2021, up from $39.17 per barrel in 2020.

Reopening favorites

The combination of several factors has made energy stocks a favored reopening trade for Wall Street, said Edward Moya, a senior market analyst with OANDA.

"The energy sector has benefited from a steady rise in oil prices that still will see more gains as global demand outlook continues to strengthen in the coming months," Moya said in an interview.

The forecast prices are well above where most energy companies planned for them to be, causing the jump in energy stocks, particularly oil and gas exploration and production companies, said Fitz of Boston Consulting Group.

But amid that price rally, the market is seeing a potentially fundamental change in these companies' goals, Fitz said.

"Typically, price goes up, money goes pouring in and because money goes pouring in, value is destroyed," Fitz said. "And what seems to be happening right now is that companies are actually speaking to a capital discipline narrative and strategy, which is really different."

Rather than focusing on growing production and acreage, Fitz said these companies will likely continue to move to pay off debt, invest less free cash into capital expenditures and improve their balance sheets.

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Discipline over growth

That focus on discipline was a common theme among the heads of the energy sector companies that had the largest increase in share price this year, including Marathon Oil Corp., Devon Energy Corp. and Hess Corp.

John Hess, CEO of Hess, said during the company's June 2 earnings call that "unbridled growth" of shale has been destructive and that U.S. shale producers have gone from a growth business to a harvest business.

"Discipline is first, second and third priority," Hess said.

Executive compensation in the sector, once almost exclusively tied to supply growth, is now focused on shareholder returns and free cash flow, said Fitz of Boston Consulting Group.

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Part of the shift is a realization amongst these U.S. shale executives that rapid supply growth following a bust cycle has caused a severe decline in the sector's weight within the S&P 500. Energy stocks, which accounted for nearly 13.4% of the S&P 500 in 2008, accounted for just 2.3% in 2020 as energy shares declined with oil prices.

"This is the accumulation of executive management's understanding that you need to change performance to permanently attract investors or the generalist investor to the sector," Fitz said.

The boom is likely to continue as the market braces for oil prices to hit $80 per barrel, but producers have shifted their focus, said Moya with OANDA.

"The pandemic forced everyone to focus on the balance sheet and defending dividends," Moya said. "The boom should continue a while."