Energy had a rough start to the year, but the sector has since bounced back, and exploration and production companies have seen the lion’s share of the gains, with SPDR S&P Oil & Gas Exploration & Production (XOP) up 15.8% year to date, more than three times the Energy Select Sector SPDR ETF‘s (XLE) 5% gain.
Certainly, crude prices have turned higher, which is a help, but that’s not the only thing going on here. Energy stocks, including formerly spendthrift E&P companies, have also shown more capital discipline in a way that’s inspiring investors. And while companies based in the Permian Basin have gotten hit by worries of a pipeline bottleneck, that at least is good news for oil prices overall.
Morgan Stanley’s Devin McDermott cites these factors and others in his bullish initiation of the large-cap E&P sector Thursday, writing that "the stage is set" for these companies to deliver strong free cash flow and capital returns "supporting continued strength in the group."
He writes that after years of spending beyond their means and disappointing investors, E&P companies are finally reaping the benefits of higher oil prices and lower supply costs, and while the tide has turned, plenty of investors haven’t realized that it’s time to get back into the sector.
McDermott believes that E&P companies’ cash-return inflection means that even if oil prices plateau, the stocks will still offer attractive capital returns. Moreover, energy is a consistent outperforming sector late in the economic cycle, he argues. While there still may be pressure on Permian stocks in the foreseeable future, more-diversified companies, and those leveraged to Brent crude–rather than West Texas Intermediary–should see gains.
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