Energy stocks posted a record year. What's next for the group?

Published Mon, Dec 27 20212:05 PM ESTUpdated Mon, Dec 27 20215:18 PM EST

In a notable turnaround, the energy sector — after years of lackluster returns, accentuated by the pandemic — is set to finish 2021 as the S & P 500's top-performing group. Energy's strength follows a recovery in oil and gas prices, but also marks a significant shift in companies' business models. Investors are now demanding healthier balance sheets, restrained spending and capital return in the form of dividends and buybacks. The sector remains under-owned – due to concerns around environmental, social and governance factors and the energy transition – but Wall Street analysts say there's upside in 2022 for companies that remain disciplined after a transformational year for the industry. Energy's banner year The energy sector is up 46% in 2021 through Thursday's close, easily putting it on track for its best year since the sector's inception in 1989. The gain follows the sector's worst year on record, when the group shed 37% in 2020 as the pandemic took hold and sapped demand for petroleum products. By comparison, the S & P 500 is up about 27% in 2021. West Texas Intermediate crude futures , the U.S. oil benchmark, plummeted into negative territory in April 2020 as the pandemic shut economies worldwide. OPEC and its oil-producing allies took historic measures, removing nearly 10 million barrels per day of oil production from the market in an effort to support prices. Producers in the U.S. and around the world also curbed production. Supply remained constrained even as demand returned, supporting oil's march higher. In October, WTI hit its highest level in seven years, while global benchmark Brent crude jumped to a three-year high. While prices have since retreated from those levels, as the Covid omicron variant took hold, both benchmarks are still on track for sizable gains this year. WTI is up 51% while Brent's gained 48%. U.S. natural gas futures are up 54% for the year, although they have eased considerably from recent highs. The contract last traded at nearly $4 per million British thermal units, after hitting $6.46 per million BTUs in October. Traditionally, this type of environment – climbing commodity prices – would have prompted producers to turn on the taps and boost production in order to capitalize on higher prices. For many years, the prevailing narrative was to grow, no matter the cost. But in the wake of the pandemic, oil and gas companies focused on slashing expenses, keeping production steady and returning money to shareholders. With ESG concerns looming, investors are also prioritizing companies focused on restraining capital spending plans while shoring up balance sheets. "The Covid-driven price collapse in 2020 brought the end of a cycle defined by overinvestment, weak returns, and persistent underperformance for the energy sector," Morgan Stanley said in a Dec. 13 note to clients. "Concurrently, it ushered in a new period of pervasive capital discipline and rising shareholder returns. … We expect this strategic shift away from growth toward FCF [free cash flow] to hold, supporting further re-rating in the sector's still discounted valuation." Overall, Morgan Stanley said the sector has a "new value proposition." RBC echoed this point, saying a structural bull market is emerging for global energy stocks following strength in oil prices and free cash flow generation, which supports balance sheet deleveraging and shareholder returns. The firm added that it expects the global integrated names to return "more to shareholders in the coming years than at any point in the last two decades." Stock picks for 2022 While energy stocks have performed well this year broadly, there has been some divergence on the sub-sector level. Exploration and production names were particularly strong, with the SPDR S & P Oil & Gas Exploration & Production fund gaining about 68% for 2021. ConocoPhillips has outperformed the group, rising 82% for the year, but analysts still view the company as an attractive bet for investors heading into 2022. Evercore ISI said the company controls top-tier assets in the Permian Basin, while also having an attractive global portfolio. The firm said the stock is "best-in-breed and a core [long-term] holding." The company has expanded its base in the shale-rich Permian Basin this year by acquiring Concho Resources in a deal that closed in January. Earlier this month, Conoco bought Shell Enterprises LLC's Delaware basin position , which is within the Permian Basin. Citi also called Conoco a top pick, while RBC said the stock is its best choice within the U.S. exploration and production universe. "COP offers a returns-focused value proposition, a strong balance sheet, and peer-leading distributions," the firm said on Dec. 15, adding that Conoco's average cost of supply is under $30 per barrel, meaning it can continue to outperform even if oil prices decline. JPMorgan, however, has a neutral rating on the stock, saying the strong balance sheet is already priced in at current levels. Within upstream producers the firm prefers Marathon Oil , which it rates at overweight. JPMorgan said the company is a leader among its peers in terms of returning cash, and forecasts Marathon's cash returns will be about 12% of the company's market cap in 2022. "We believe that the company will continue to maintain its financial discipline, with no appetite for expensive M & A in terms of portfolio renewal," the firm said. Energy stocks inevitably follow oil prices, and estimates for where oil will trade over the coming years vary widely. Some firms, including Goldman Sachs and Bank of America , have said prices could top $100 as demand strength and under-investment in the sector – which means curbed supply – boost prices. Goldman's base case, however, is for Brent to average $85 in 2022 and 2023. The emergence of a new Covid variant could wreak havoc on demand. If OPEC and its allies adjust output, that could skew the supply side of the equation, bringing down oil prices. Morgan Stanley noted that after the recent pullback in oil prices, the setup looks increasingly attractive. "We expect capital discipline, ESG pressure on fossil fuel investments, and a more cautious view on OPEC to keep supply growth in check while demand continues to recover, a combination that is supportive for prices," the firm said in a Dec. 13 note. Morgan Stanley has an overweight rating on integrated giants ExxonMobil and Chevron , both of which have outlined capital return as a priority moving forward. Each company has also said it will work to reduce emissions, allocating billions of dollars for new initiatives. Morgan Stanley said Chevron offers investors "peer-leading cash flow anchored by low-risk investments," while noting that Exxon has a rapidly improving balance sheet. Bank of America also has a buy rating on shares of Exxon, which are up 49% for 2021. "ExxonMobil remains the only major oil to emerge from the COVID downturn as a growth stock, with significant capacity to sustain and grow its per share dividend, through doubling cash flow and a reset in portfolio cash breakeven, confirmed at $35 Brent," the firm said in a Dec. 1 note. Oilfield-services companies are also still in the green for the year, although the group has underperformed the broader energy complex. The VanEck Oil Services ETF , which tracks the space, is up just 22% for the year compared to the high-flying returns elsewhere. RBC said Schlumberger is its best idea within the group, saying its size and geographic diversification make it "favorably positioned under prevailing industry trends." The company's market cap is about $41 billion, according to FactSet, making it the largest player in the space. Evercore ISI also called the company a top pick, saying it's "extremely well positioned for the unfolding upcycle due to its heavy international exposure, capital disciplined approach, leading digital businesses and leveraging the benefits of size, scale and scope." Citi, too, has a buy rating on shares of Schlumberger, although the firm's top pick in the space is oilfield-services company NOV . "Rising end market demand and fading supply chain issues should drive positive revisions," the firm said of NOV. While traditional energy stocks have excelled this year, renewable energy stocks have floundered. The iShares Global Clean Energy ETF is down 25% for 2021, after more than doubling in 2020. With so much attention focused on energy transition, some oil and gas companies are saying they can be a part of the solution, particularly in areas like carbon capture. The extent to which these companies pivot to greener operations remains to be seen, but in the meantime RBC said the group can once again attract investors who might have fled the sector after years of underperformance. "We think the sector is better placed now than at any point over the last two decades," the firm said in a Nov. 16 note. "The energy-transition narrative is also becoming more nuanced, with potential for the majors to move from being part of the problem to being part of the solution towards net zero." - CNBC's Michael Bloom contributed reporting.

The sun is seen behind a crude oil pump jack in the Permian Basin in Loving County, Texas.

Angus Mordant | Reuters

In a notable turnaround, the energy sector — after years of lackluster returns, accentuated by the pandemic — is set to finish 2021 as the S&P 500's top-performing group.

Energy's strength follows a recovery in oil and gas prices, but also marks a significant shift in companies' business models. Investors are now demanding healthier balance sheets, restrained spending and capital return in the form of dividends and buybacks.

The sector remains under-owned – due to concerns around environmental, social and governance factors and the energy transition – but Wall Street analysts say there's upside in 2022 for companies that remain disciplined after a transformational year for the industry.