Breaking Down the Energy Sector Reveals Not All Oil Stocks are the Same

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(Wednesday Market Open) The Consumer Price Index (CPI) was released before the open, revealing that inflation grew 7% year-over-year, but core CPI grew at 5.5% year-over-year and 0.6% month-over-month. Inflation hasn’t grown this quickly in 40 years. While the 10-year Treasury (TNX) yield traded 0.29% higher on the news, equity index futures actually traded higher after the CPI report.

If I told you that the 10-year Treasury yield would be up about 25 basis points by January 12 from the beginning of the year, you’d probably think we were getting killed in the stock market. But stocks continue to show more resilience as investors apparently believe there’s still room for growth. Last week we saw mortgage applications were higher in December, which suggests many homebuyers may be looking to lock in a rate before they rise.  

We may still see more volatility in the near future, but—with a change in focus on earnings starting at the end of this week—investors may be able to shift to the growth story.   

With that said, some stocks were already falling in premarket action before the CPI report. Biogen (BIIB) fell 9.8% in premarket trading on news that Medicare would only cover the Biogen’s Alzheimer drug Aduhelm for certain recipients. The news also caused Eli Lilly (LLY) to fall 1.7% because it has a similar drug.

Jefferies Financial (JEF) handed out a few upgrades that resulted in premarket movement. PayPal (PYPL) was downgraded from buy to hold prompting a 2.3% premarket selloff. DoorDash (DASH) was upgraded leading to a 2.8% rally respectively.

Stocks were mixed during the morning trading session on Tuesday but turned bullish in the afternoon session with the Nasdaq Composite (GIDS) leading the charge. The tech-heavy Nasdaq rose 1.41% while the S&P 500 (SPX) followed, closing 0.92% higher. The market rally appeared to coincide with Fed Chair Jerome Powell concluding his testimony before the Senate banking committee. Chair Powell didn’t say anything new and confirmed that the Fed plans to end all its bond-buying stimulus in March. Apparently, investors just wanted assurance that the Fed hadn’t changed its plans.

The 10-year Treasury yield (TNX) fell 1.91% and rested just above its March 2021 highs. However, crude oil prices rallied 3.96% in part from a report by the U.S. Energy Information Administration (EIA) boosting its 2022 crude price outlook by $5 per barrel. Even before the EIA made its announcement, investors were already buying energy stocks again. The Energy Select Sector Index rose 3.42% on the day and led all other sectors.

The technology sector was the second strongest, with the Technology Select Sector Index rising 1.21%. Semiconductors helped technology stocks rise. The PHLX Semiconductor Index (SOX) rallied 1.84%.

Burning Calories

Oil and gas stocks have sprinted out of the block in 2022 and left all other sectors in the dust. The question is, are they good for the long run? When discussing inflation, gas and groceries are commonly the first products people think about because those are the products more often purchased. The ability of energy to maintain its lead may depend on how long inflation will continue to grow at a heightened pace. The Fed is committed to reducing inflation to its previous target of 2% per year, but many analysts think the Fed is behind inflation and may need to take aggressive actions to get back on top of inflation. However, there’s also questions on whether the Fed will have the political will to slow economic growth quick enough during a midterm election year. Whatever happens, it appears inflation and, by extension, energy may have a little more endurance than the Fed originally expected.

Over the last six months, investors have bought energy stocks, and exploration and production companies have been the top performers. Refiners and marketers have been the second-highest group, while oil equipment companies have trailed behind. It’s difficult to break up these groups because many large oil companies are integrated across groups.

You may be surprised to learn that not all energy companies benefit from rising oil prices. It largely depends on where they fall in “stream”. Generally speaking, upstream companies tend to profit from rising oil prices, but downstream companies are often hurt by rising prices. 

CHART OF THE DAY: MAKING THE GRADE. The S&P Oil & Gas Exploration & Production Index ($SPSIOP—pink) has outperformed the Oil & Gas Refining & Marketing Subindustry group ($SP500#10102030—candlesticks) and the S&P Oil & Gas Equipment Select Industry Index ($SPSIOS—blue). Data Sources: ICE, S&P Dow Jones Indices. Chart source: The thinkorswim® platform. For illustrative purposes only. Past performance does not guarantee future results.  

Upstream: Oil exploration and production companies are “upstream” segments of the energy sector because it includes the searching, exploring, testing, drilling, and extraction phases of oil and gas. In the S&P 500, these companies include ConocoPhillips (COP), EOG Resources (EOG), Pioneer (PXD), and Devon (DVN) to name a few. Upstream companies tend to be most sensitive to oil prices because there are certain price points that oil must meet in order for certain wells to be profitable enough to cover their costs and make extraction worthwhile. This means they’re also quick to fall if oil prices fall.

Oil services companies like Halliburton (HAL) and Baker Hughes (BHI) provide engineering, maintenance, surveying, testing, and so forth, up and down the stream. However, upstream activity is commonly where their services are in higher demand. So, they also tend to be sensitive to oil prices.

Midstream: Oil storage and transportation companies are midstream companies that transport and store raw oil. They may use pipelines, trains, or trucks to get oil from the drillers, to storage, and finally to refiners. The S&P 500 oil storage and transportation companies are Kinder Morgan (KMI), Williams (WMB), and ONEOK (OKE).

Upstream and downstream companies come together in favor of more pipelines because they tend to keep the costs lower than trucks and railroads. Enbridge (ENB) and Energy Transfer (ET) are two companies that specialize in building pipelines, but many of the other companies named here are also in this space.

Downstream: Oil and gas must be refined before it can used. This is where the refining and marketing groups come in. These companies create gasoline, heating oil, synthetic rubber, plastics, lubricants, pesticides, and much more. Then they get these products to consumers through marketing and selling or by selling products through non-energy companies. In the S&P 500, these companies include Marathon (MPC), Phillips 66 (PSX), and Valero (VLO).

Large companies that you commonly think of when discussing energy like Exxon Mobil (XOM) and Chevron (CVX) are also refiners, but they also participate in the other phases too.

Downstream companies can actually be hurt by rising oil prices because crude oil can’t be exported; only refined products can be exported. This means that once a refiner hits maximum capacity, it can no longer keep up with demand.

All of energy is capital intensive. This means a lot of costs in machinery and raw materials have to be spent before money can be made. It can also take a lot of time to get wells, pipelines, trucks, refiners, etc. up and going. This means it will take time before oil production can meet demand and pull prices lower.

TD Ameritrade® commentary for educational purposes only. Member SIPC

Image sourced from Pixabay

This post contains sponsored advertising content. This content is for informational purposes only and not intended to be investing advice.