Energy Funds Lead Again, but Ukraine War Makes Future Uncertain

The frantic race in energy markets shows no signs of abating. After topping the charts in 2021, funds that invest in energy stocks again posted the best performance of any sector in the first quarter.

But some investors wonder how long this streak can continue in the face of growing uncertainty, with European leaders debating cutting Russian imports, and as sanctions, inflation and the pandemic threaten global growth.

“I don’t think I would add energy exposure now,” said John Maloney, chairman of M&R Capital Management, a New York-based wealth management firm. “Stocks may have more impact, but you don’t need to grab every last dollar of profit.”

Energy funds rose 32% in the first three months of the year, by far the biggest return of any sector. In 2021, as demand rebounded from the depths of the Covid-19 pandemic, energy equity funds gained 40.9%, compared to a 26.9% rise for the S&P 500.

As is often the case, the actions of energy companies have been inspired by oil prices. Brent crude, the closely watched global benchmark, hit an intraday high of nearly $140 a barrel on March 7 – its highest level since 2008 – as the United States prepared to ban the entry of Russian energy products. in the country. It has since stabilized closer to $100 a barrel, and the U.S. Energy Information Administration predicts it will trade at an average of $105 a barrel this year, well above the 71 average. dollars in 2021.

European Union leaders continue to debate the speed and severity of reducing their dependence on Russian energy. But even without a complete ban on Russian energy in Europe, many companies avoid it. “There’s a scarlet letter attached to buying from Russia,” said Tom Kloza, global head of energy analysis at Oil Price Information Service. This could cause oil prices to rise globally.

EU leaders also announced ambitious plans to buy more liquefied natural gas from US producers. Even before Russia’s invasion of Ukraine – and Russian President Vladimir V. Putin’s threat to turn off the tap if countries did not pay in rubles – low natural gas inventories and record prices in Europe were pushing American producers to send more gas there. . European LNG imports from the United States hit a record high in December, which has since been surpassed in January and February.

But there is a catch. The United States, the world’s largest energy producer, does not have much spare oil or gas capacity.

“The barrier to many LNG projects on the Gulf Coast has not been government approval, but lack of financial support,” said Jason Bordoff, founding director of the Center on Global Energy Policy at the Columbia University. “But the Europeans have sent a signal that they intend to sign longer-term contracts for LNG supply, so this should help these projects make final investment decisions.”

It’s not just funders who are hesitant to fund new exploration and production activities. Shareholders have demanded a bigger share of profits after years of lousy returns on investment in energy funds. A typical investor who bought an energy equity fund five years ago wouldn’t have broken even until recently, according to Morningstar Direct. Thus, the energy industry has focused on shareholder returns rather than pouring profits back into its operations, a strategy markets call capital discipline.

“Capital discipline isn’t just about the areas you’re going to explore,” said David Lebovitz, global market strategist at JP Morgan Asset Management. “The new approach is to go to profitable fields and drill five to seven wells, instead of 10. If you’re an energy company, you don’t want to overwhelm the world with oversupply.”

In the portfolios Mr. Maloney manages for his clients, he includes the exchange-traded fund Vanguard Energy. This $8.3 billion fund posted returns of 39% in the first quarter after a management fee of 0.1%. Exxon and Chevron are the top two holdings, with a combined weighting of 38%. Exxon shares rose 36.5% in the first three months of the year; Chevron shares rose 40.1%.

Chevron has suspended sales of certain chemicals and consumer products to Russia and says there are no exploration or production operations there. It has a 15% stake in a pipeline that carries crude oil from Kazakhstan to a Russian terminal on the Black Sea, where shipments have continued uninterrupted. There, Kazakh oil can be blended with Russian crude, although Chevron said its “efforts are being conducted in accordance with US law”.

Exxon, which has done much more business in Russia, announced on March 1 that it was leaving the country and would not make any further investments there, “given the current situation”. It operated a major exploration project in the Russian Far East known as Sakhalin-1.

Mr Maloney said that after the surge in stock prices over the past year, he mainly viewed energy stocks as a hedge against other holdings that could move in the opposite direction, such as airlines, shippers and other fuel-sensitive businesses. prices.