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Beaten-Down Energy Stocks Are Poised to Power Higher


The sun shines behind an oil pump jack in Sweetwater, Texas. Analysts see the energy sector on the rise and have been broadly encouraging investors to increase their exposure.
The sun shines behind an oil pump jack in Sweetwater, Texas. Analysts see the energy sector on the rise and have been broadly encouraging investors to increase their exposure.
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Spencer Platt/Getty Images

The first quarter wasn’t kind to energy companies: the stocks suffered their worst three-month period in three years.

Now some investors think there are bargains to be had.

Energy shares in the S&P 500 fell 6.6% in the first quarter, extending 2017’s 3.8% slide. After surging in December and January as oil prices neared $70 a barrel, the sector plunged in early February as the broader market fell on fears about the potential for rising interest rates. Only telecommunications and consumer staples in the S&P 500 fared worse in the first three months of the year.

But, thanks to solid corporate earnings and higher oil prices, analysts say the sector is poised for a comeback.

Energy companies, which posted the strongest earnings growth of all 11 major sectors in the S&P 500 in the latest period, are expected to outperform again when the first-quarter reporting season kicks off. Meanwhile, oil prices rose 7.5%, to $64.94 a barrel, in the first quarter and are continuing to build momentum, having risen six of the past seven months.

A recovery in share prices is also taking hold: energy stocks climbed 1.6% in March, outperforming the broader S&P 500, which fell 2.7% on tumult in the technology sector.

Michael Scanlon,

a portfolio manager with Manulife Asset management, says the disconnect between the weak share prices of energy companies and their vastly improved earnings and cash flows has created an “incredible” situation in which the stocks are at their most appealing valuations in years.

“Those cash flow streams going out into the future are far more valuable, yet the stock prices haven’t kept in sync with that,” Mr. Scanlon said. “That’s an environment where oil can be held higher from here. Those stocks are very attractive.”

After the recent declines, energy companies’ valuations are more in sync with the broader market, analysts say. The shares are trading at 20 times their forward-looking earnings over the next 12 months, compared with 16 times for the broader index, according to FactSet.

“The selloff brought valuations back in line to where they are much more balanced than they were 18 or 24 months ago,” said

Patrick Palfrey,

an energy equity analyst with Credit Suisse, which recently upgraded allocations to energy stocks to “market neutral” from underweight. “We’re quite confident that the growth potential for the group remains strong.”

Analysts are broadly encouraging investors to increase their energy exposure. About 59% of their projections for energy stocks include “buy” ratings, according to FactSet’s data, putting energy among the sectors with the highest number of buy ratings—the others being technology and health care.

That is partly because energy companies are projected to boost earnings by 79% in the first quarter, the most of any other sector, in part because of higher oil prices. The S&P 500, altogether, is expected to grow earnings 17% in the first quarter.

At the same time, many of the energy companies that suffered through the oil rout that began in 2014 are operating more efficiently, with U.S. shale companies building more cost-effective wells. That is helping many companies again generate free cash flow.

Some of that cash is expected to end up in the hands of investors. Energy firms are expected to return some $53 billion in cash to investors this year, a 5% increase from 2017, according to a Morgan Stanley research note. About 75% of the cash returned to shareholders this year will be through dividends, with the remainder via share buybacks.

Despite the better prospects for energy stocks, some investors worry that the sector’s outlook could change suddenly. Some reports show oil and gasoline are accumulating in storage, while U.S. production is also expanding, two of the primary factors that spur volatility in oil prices.

A surge in oil and gas reserves would drive down prices, potentially starving companies of their free cash flow. Energy companies need oil prices to be somewhere between $40 and $50 a barrel to sustain break-even cash flow, Morgan Stanley said, and if prices were to tumble below that, companies could be forced to cut back their spending drastically.

“This creates concern if oil prices retrench toward that threshold,” Morgan Stanley said in its research note, “”producers may have to consider suspending buybacks, cutting dividends or even look to raise equity.”

Write to Michael Wursthorn at Michael.Wursthorn@wsj.com

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