What could one of the most neglected and abandoned sectors in the S&P 500 possibly have in common with TSLA? Well, despite a litany of differences we think XLE will be a top performer in 2021 for a very similar reason to why TSLA was one of the best performers in 2020; institutional Fear Of Missing Out (FOMO). TSLA was responsible for nearly three quarters of the Russell 1000’s gain at a point last year and most Russell 1000 money managers had zero exposure to it. The subsequent rush into TSLA caused by not having one of the top performers in institutional portfolios was one of the primary drivers behind the stocks’ parabolic price-surge of 2020.

Source: FSInsight

Given that energy’s sector-wide valuation is near replacement cost and the surviving companies have had to significantly boost operating leverage to survive, we think that Energy may provide some of the most compelling opportunities of 2021. The fact that many institutional investors have a zero-weighting combined with the positive and powerful cyclical economic forces likely to emerge in the near future makes this one of our top three recommended sectors for the coming year. The rush of institutional investors to get into one of the best performing sectors causes prices to move higher and faster than almost any other market force. Thus, we think you want to be OW or at least neutral energy to capitalize on the collapse in Equity Risk Premia (rise in valuation) that could very well be around the corner for the energy sector.

Many accredited investors have made the decision that Energy, one of the consistent underperformers of the last years, ultimately was so insignificant that they could afford to put a zero-weighting in the sector in favor of larger, alpha-seeking positions in the Amazons, Googles and Apples of the world. All of these stocks comprise a greater proportion of the S&P 500’s market-cap individually than the entire Energy Sector.

Despite this low weighting, the performance of energy stocks in the first two weeks of the year gave preview to why the situation could change quickly, particularly if perceptions on the healthcare situation are more negative than the reality, which may be the case. If energy, ends up comprising a substantial portion or majority of the S&P 500’s gains for the year, institutions will have no choice, as they did with TSLA, but to pile in quickly in order to provide acceptable returns to their clients. No one wants to be without a chair when the music stops. Similar to TSLA in 2020, the pile-in that occurs in energy when the commodity super-cycle that has recently been predicted kicks in, we believe this institutional FOMO will cause significant price appreciation of strong equities in the energy sector, and likely the sector as a whole.  

Source: Fundstrat

Inflation Risk Is Likely to The Upside, Commodities Super-Cycle Beginning?

Talk of a new commodity super-cycle and ample indicators of reflationary forces are in the air. There is a very baseline piece of logic to our contrarian bullish call on energy; despite all the exciting developments in Electric Vehicles and renewables the upcoming economic boom will be powered primarily by oil, or not at all. Many of the supply-side restrictions when coupled with the cuts energy firms have had to make; like laying off 14% of permanent employees in 2020, will produce greater EPS. Additionally, CAPEX has significantly declined which could lead to supply issues over the medium-term. These issues would likely boost the margins of domestic producers.  The much-decried anti-energy policies of the Biden administration are actually supportive of part of our bull-thesis; the administration will act in ways that will diminish the supply  but restrictions will not be so excessive as to force preliminary extinction. The recent revocation of the Keystone permit and forbidding drilling on Federal lands support this. The energy sector has at least one great cycle ahead of it yet.

Energy is an ‘Epicenter’ sector. It is also the hardest hit of the ‘Epicenter’ sectors. While there are certainly many idiosyncratic risks to the sector, we also think it may be a leader in gains for several reasons. Rising inflation expectations are certainly a positive for energy. A bet on ‘Epicenter’ is implicitly a positive beta bet on rising inflation. If you are worried about inflation you want to be overweight ‘Epicenter’, and Oil and Gas companies benefit two-fold, as their high asset intensity, including in oil reserves, serves as a natural hedge against inflationary forces. On a more secular level, we think macro-forces attracting capital to equities in favor of bonds will re-rate the entire P/E ratio of the S&P 500 higher; energy having one of the lowest valuations will likely be a leader in this general move higher as leaner and meaner corporate entities with greater earning power come up against higher-than consensus demand paired with supply constraints.

Alt. Data, Accommodative Monetary Policy, And Potential Supply Constraints Support Bullish Thesis

We looked at some alternative data from China. This is provided DeepMacro and measures NO2 levels YoY, which is a proxy for manufacturing activity. As you can see, it is accelerating and looks likely to pass November levels; this would also support the conclusion that GDP growth is accelerating and has not yet peaked. This in conjunction with dovish Central Banks and ample fiscal support from governments suggests inflation could be higher than expectations.  ISMs and PMIs have also been largely positive and in some cases well-above consensus estimates. This suggests that GDP growth has not yet peaked, but is still accelerating. The implications of this and other pieces of positive economic data are that the demand for oil over the coming quarters could be significantly higher than consensus expects.

Another bullish factor for Energy that many folks may have missed is that many major players in the industry used COVID-19 to accelerate investments in automation and technology that should enhance profitability, especially when paired with the deep cuts these companies have had to make to survive their worst down-cycle in a long time. Many players have begun ‘variablizing” their fixed costs.

Source: HP Company Reports

How Long Do Bull Markets In Energy Typically Last?

Energy stocks had a great start to the year and experienced some volatility in the second half of January. However, we think it is very early innings for the energy rally, and we had our data science team compare recent relative performance to other bull markets. The implication seems pretty clear. If you believe energy will outperform and will be a major beneficiary of inflation and supply constraints, which we do, then it seems pretty clear from historical data that its a good possibility there is plenty of upside left for Energy in 2021.

Source: FSInsight, Bloomberg and FAMA

Risks And Where Could Be Wrong

Political risk in the United States could end up being higher than the current situation and balance of legislative power would suggest. Also, if the Federal Reserve begins implementing ‘Climate Scenarios’ in its supervisory stress test, it could further alienate the industry from capital it will likely need. However, GOP opposition to this has already been publicly stated. We also think at the end of the day, the Federal Government has very little interest in creating the significant employment and regional disruptions that would occur as a result of too stringent a regulatory approach to an Energy industry that just survived a once-in-a-generation crisis.

Our Favorite Energy Stocks

Source: FSInsight