Opinion: 5 reasons to love unloved energy stocks – and 10 ways to buy them

First, the unloved part. Investors are the most underweight energy that they have been since December 2020, according to Bank of America’s global fund manager survey. Hedge fund exposure to energy is at an all-time low, B of A notes. 

You can also tell energy stocks are unloved, by their valuations. Giants Exxon Mobil
XOM,
+1.13%
and ConocoPhillips
COP,
-0.06%,
for example, both trade at steep discounts to their five-year average valuations, as do Baker Hughes BKR
BKR,
+1.78%
and Schlumberger
SLB,
-0.51%
in services.  

Here is a measure of how much energy stocks trade at a discount to the broader market. The energy sector produces a 10% free cash flow yield, compared to 5% for the S&P 500
SPX,
notes Rob Thummel, an energy sector expert who manages the Tortoise Energy Infrastructure fund  TORIX. Like dividend yield, free cash flow yield rises as stock prices decline. 

Here are five reasons why energy stocks and oil and natural gas prices should move higher from here. 

1. Winter is here: A sustained blast of cold weather will boost demand for natural gas, and natural gas prices. This will help natural gas producers, and oil companies that produce a lot of natural gas as a byproduct of crude production. 

WeatherBELL Analytics Thomas Downs expects a severe cold period from late January through February for the eastern two thirds of the country. “Later January into February could turn brutal,” he says. The upshot will be an above-average number of heating degree days during most of the rest of the winter. Heating degree days are a measure how far average temperatures sink below a benchmark. WeatherBELL’s prediction adjusts for natural gas usage, giving greater weight to populated areas. 

2. Economic growth will support energy demand: U.S. growth — and global economic growth — in 2024 will drive energy demand higher, and energy prices as well. “If we achieve a soft landing in the U.S. and other countries around the world, demand will set a new record this year,” Thummel says. He thinks daily global energy usage will rise by more than 1 million barrels. For context, global oil usage has been at about 100 million barrels per day (BPD). 

3. Supply growth will be contained: Big U.S. production growth in 2023 was a surprise, as energy companies got better at extracting oil from shale. But the U.S. growth will slow down in 2024, predicts energy sector expert Ben Cook, who manages Hennessy Midstream Fund HMSFX and Hennessy Energy Transition Investor HNRGX). 

Meanwhile, OPEC+ production discipline will continue, he says, which will also limit supply growth. “We continue to see a very strong commitment to maintaining price stability, cutting production and keeping prices at levels where they can maintain their social spending,” Cook says. “We expect crude prices to gradually improve over the course of the year.” He thinks West Texas Intermediate crude
WBS00,
-0.24%
could rise to $80 a barrel or more in the second half of 2024.

Here’s a view from Wall Street: J.P. Morgan energy analyst Natasha Kaneva thinks Brent oil
BRN00,
-0.33%
should average $83 a barrel in 2024. She cites an expected 1.6 million BPD increase in global daily oil consumption, supported by robust emerging market growth and U.S. economic strength. She also expects a slowdown in non-OPEC+ supply growth to 1.6 million BPD from 2.2 million BPD in 2023. 

4. Yield-hungry investors will gravitate to energy as bond yields fall: As investors become more convinced that inflation is tame, and a Federal Reserve rate-cutting campaign lies ahead, interest rates will continue to soften. This will have fixed-income investors looking for better yield options, says Thummel. So, they will be checking out energy stocks. Energy companies like Exxon Mobil and ConocoPhillips offer dividend yields in the 4% range. Energy companies also offer earnings growth potential, strong balance sheets, and free cash flow supporting stock buybacks, Thummel adds.

5. The wild card here is geopolitical risk: If the conflict in the Middle East escalates to disrupt the oil trade, oil prices will spike, pushing energy and energy services stocks higher. But even without that escalation, investors now seem way too complacent — which also suggests oil prices should be higher. 

“Clearly, geopolitical risks appear to be on the rise,” Thummel says. He thinks West Texas Intermediate should trade at around $80 right now based on supply-demand fundamentals alone. But WTI goes for about $75 per barrel, which means there is currently a negative geopolitical risk premium in oil. “That makes no sense to me given all the rising tensions in the oil regions,” he says. “We should have geopolitical risk premium.”

How to get energy sector exposure

One option is mutual funds. For example, Cook’s Hennessy Midstream Fund pays a 10.1% yield and offers exposure to limited partnerships and master limited partnerships (MLPs) in energy without the messy tax-time implications. Morningstar Direct says his fund beats competing energy limited partnership funds and the Morningstar MLP Composite index by several percentage points over the past year. His Hennessy Energy Transition Investor fund also beats competing funds and Morningstar’s energy index over the past year.

Thummel’s Tortoise Energy Infrastructure fund offers a 4.4% yield and carries a four-star rating, out of five, at Morningstar Direct. For individual stocks, Thummel singles out Energy Transfer
ET,
+0.43%,
an energy infrastructure play; Cheniere Energy
LNG,
+0.10%,
a U.S. liquid natural gas (LNG) exporter; and Williams Companies
WMB,
-0.06%
in natural gas infrastructure.

Energy Transfer’s dividends and earnings could grow 3%-5% a year, says Thummel. The company benefits from rising U.S. energy exports. Cheniere is the largest LNG exporter in the world, and it will benefit from rising global demand for U.S. LNG over the next few decades, he says. Likewise, the U.S. natural gas infrastructure company Williams stands to gain from this trend, and the reshoring of industry which boosts natural gas demand as well, he says. 

Cook at Hennessy says the midstream infrastructure space is the most attractive as it has been in a decade. He cites declining debt levels, rising U.S. production underpinned by a strong foreign demand for U.S. energy, and more stable commodity prices. The top holdings in his midstream fund include Energy Transfer, Enterprise Products Partners
EPD,
+0.15%
and Plains All American Pipeline
PAA,
-1.51%.

For energy stocks in general, Cook looks for quality, large-cap names with strong management, and low-cost structures that can limit downside during oil price declines and produce better upside when oil rises. He also favors companies returning a lot of cash to shareholders via dividends and buybacks. Here, he cites Exxon Mobil, ConocoPhillips and Cheniere, all holdings in his Hennessy Energy Transition Investor fund.

In energy services, Baker Hughes and Schlumberger appear on the top-10 list of most popular energy stocks among Bank of America fund manager survey respondents. Normally, crowded names can be risky. But here, I’ll take the rankings as a sign of quality at these two services names.  

Michael Brush is a columnist for MarketWatch. At the time of publication, he owned XOM and COP. Brush has suggested XOM, COP, BKR, SLB, ET, LNG, WMB and EPD in his stock newsletter, Brush Up on Stocks. Follow him on X @mbrushstocks.

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