Energy stocks have generated the highest return of all 16 equity sectors during rising rate environments, which is a positive factor as the Federal Reserve raised rates in March and plans to increase them again this year.
“This bodes well for the energy sector in the coming months and years, as most analysts expect the trajectory of interest rates to rise,” says Robert Johnson, principal at the Fed Policy Investment Research Group in Charlottesville, Virginia.
While some experts predict that the central bank will raise interest rates twice, others have said it could be as many as three since a rate hike in June is a virtually a certainty.
“The Fed pledges to maintain their gradual pace of rate hikes despite inflation moving close to their 2 percent objective with some wiggle room for it to run slightly above that,” says Greg McBride, chief financial analyst for Bankrate, a New York-based financial data and content company. “The movement in inflation will squarely shift the outlook to four rate hikes, rather than just three, by the time 2018 draws to a close.
“With inflation now on the cusp of that threshold, the Fed may become more proactive about raising rates in an effort to keep inflation contained,” he says. “If anything, the pace of increases is likely to pick up rather than back off.”
Energy stocks performed very similarly in rising and falling interest rate environments from 1966 through 2016 – the energy sector returned 12.1 percent when rates were falling and 10.1 percent when rates were rising, Johnson says. Over the same duration, the Standard & Poor’s 500 index returned 15.2 percent when rates were falling and only 5.8 percent when rates were rising.
Rising interest rates are tied to rising inflation, says Rob Thummel, a portfolio manager with Leawood, Kansas-based Tortoise Capital, which has $14.3 billion under management invested in energy stocks.
“Energy is the best-performing sector in the S&P 500 during periods when inflation rises by 3 percent or higher,” he says.
There appears to be more upside risk than downside in the price of oil currently, which could help oil companies in the months ahead, says Patrick DeHaan, a senior petroleum analyst for GasBuddy.com, a Boston-based provider of retail fuel pricing information and data.
“Issues like Iran, OPEC’s oil production, high U.S. oil exports and high demand all remain potential issues driving prices up,” he says.
Crude oil prices are predicted to rise this summer as U.S. commercial oil inventories have declined close to 100 million barrels compared to year ago. “With refiners humming along, the gains could help oil producers more than refiners,” DeHaan says.
One catch is that as interest rates rise, they lead to a stronger dollar, which puts downward pressure on oil prices and oil stocks, says Bruce Bullock, director of the Maguire Energy Institute in Dallas. “We haven’t seen too much of that impact yet, but we still might as interest rates continue to normalize. Higher interest rates do directly put downward pressure on pipeline stocks organized as MLPs.”
The continued resolution of the Korean conflict could have a downward impact on oil prices and stocks, but the looming deadline on certification of Iran’s compliance with the nuclear deal and a potential Iran-Israel conflict could add upward pressure on oil prices and lift stocks.
Oil prices face other potential headwinds with President Donald Trump’s announcement that the U.S. will withdraw from the nuclear deal with Iran. The decision means that as much as 1 million barrels of oil a day in supply could be disrupted in the future, based on analysts surveyed by New York-based S&P Global Platts. A supply shortfall could in turn boost crude oil prices and benefit exploration and production producers.
Since the market appears to be tight, oil prices and the energy sector are not likely to be affected by the sanctions, says William Featherston, a Credit Suisse analyst in a research note.
“Our supply/demand balances imply a bullish outlook for crude even if Iranian production/exports are unaffected,” he says. “We continue to believe the backward-dated futures curve materially undervalues long-term oil prices.”
The top exploration and production picks by Credit Suisse are Marathon Oil Corp. (ticker: MRO), WPX Energy (WPX), Anadarko Petroleum Corp. (APC), Noble Energy (NBL), Pioneer Natural Resources Co. (PXD), Continental Resources (CLR), Viper Energy Partners (VNOM) and Extraction Oil & Gas (XOG). The investment bank says it has underperform ratings on Chesapeake Energy Corp. (CHK) and QEP Resources (QEP).