Energy Stocks Perform Well When Interest Rates Rise - TheStreet

Energy stocks tend to perform well in a rising interest rate environment, outpacing the S&P 500's average gains when the 10-year Treasury yield rose above 2.74% as investors focus on their performance in the fourth quarter with the odds of the Federal Reserve raising interest rates increasing.

When the 10-year Treasury yield is too low, stocks in the S&P 500 energy sector decline compared to the benchmark.

Since 1990, the S&P 500 energy sector posted an average six-month price decline of 2.2% when the 10-year yield was in the lowest quintile of 1.50% to 2.72%, compared to the S&P 500 which gained an average of 3.1%, said Sam Stovall, chief investment strategist at New York-based S&P Capital IQ.

The energy sector outpaced the S&P 500 in the next two quintiles and rose 5.4% when rates were between 2.74% to 4.17%, compared to the S&P 500's average advance of 1.9%, he said. The sector also gained 6.9% when rates were between 4.18% and 5.16%, compared to the market's 2.2% average gain.

The S&P 500 gained an average of 5.0% compared to all sectors during the fourth quarter, Stovall said. All 11 of its sectors rose in price, however the energy and real estate sectors tied with the lowest average fourth quarter change of 1.9%.

Energy stocks have performed well in a rising rate environment, which bodes well for investors since the current consensus is that the Fed will raise rates at their December meeting, said Robert Johnson, president of the American College Of Financial Services in Byrn Mawr, Pa. The chance of them raising it rises to nearly 70%.

From 1966 through 2014, energy stocks returned 12.1% when rates were falling, 11.2% when rates were rising and 14.3% when rates were stagnant.

"In fact, in a rising rate environment, the 11.2% return was the highest return of the 16 sectors we examined," he said.

The second highest performing sector was consumer goods which generated a return of 8.1%, followed by utilities at 7.95%.

"In essence, the return to energy stocks has been remarkably consistent across different interest rate environments," Johnson said. "This contrasts dramatically with the automobile sector, which generated returns of 25.3% when rates were falling, 9.9% when rates were stagnant and negative 1.4% when rates were rising."

Brent crude, the international benchmark for oil prices, is estimated to average $43 per barrel in 2016 and $51 per barrel in 2017, according to the Energy Information Administration. Price for the U.S. benchmark, West Texas Intermediate (WTI) crude oil prices are forecast to average about $1 per barrel less than Brent crude for both 2016 and 2017.

"The current values of futures and options contracts suggest high uncertainty in the price outlook," the EIA said in a statement. "NYMEX contract values for January 2017 delivery traded during the five-day period ending October 6 suggest a price range from $37 to $68 encompasses the market expectation of WTI prices in January 2017."

Oil prices will remain stable until the next OPEC meeting on November 30 while the market waits for direction on how much production will be slashed, said Rob Thummel, a portfolio manager with Tortoise Capital in Leawood, Kan. which has $13.5 billion under management invested in energy stocks.

"OPEC has run out of patience and wants oil prices to stabilize and move higher," he said. "With stable oil prices, the table is set for energy going forward."

Many institutional investors have underweighted the energy sector, however more stable oil prices could " change their view on the sector," Thummel said.

Oil and gas producers are expected to increase their capital spending next year after two consecutive years of capital expenditure cuts with the first production increases estimated to occur in the Permian Basin, he said.

An interest rate increase in December means that energy infrastructure companies with sustainable dividend yields of 5% to 7% "look appealing as investors search for yield in a 1.5% to 2% 10-year Treasury environment," Thummel said.

Even stocks for refiners may appear more appealing as their margins should improve.

"Refiners believe the worst is over with regard to their margins," he said. "Better margins combined with continued strong demand for gasoline and increased refined product exports provide some positives for a sector that has been one of the worst performers during 2016."

Balance sheets and locations are still the two main factors driving exploration and production stocks, said Bruce Bullock, director of the Maguire Energy Institute at Southern Methodist University's Cox School of Business in Dallas.

"At current prices, those companies with strong balance sheets and with good acreage positions in the Permian Basin will continue to deploy rigs which will increase production, cash flow and earnings," he said. "As long as prices remain above $50, these companies will be able to hedge activities for 2017 to protect their cash flow and limit downside risk."

Low interest rates have enabled highly leveraged companies to maintain their debt service at lower oil prices, said Ben Dickey, a portfolio manager on Covestor, the online investing company, and founder of BSG&L Financial Services in Houston. EOG Resources (EOG) - Get Report , Concho Resources (CXO) - Get Report and Pioneer Natural Resources (PXD) - Get Report are companies which have good balance sheets.

"EOG is the best run company, in my opinion because they have lower costs and are making money in the $40's," he said. "Concho is another well run company and most of their reserves are also in the Permian."

Some midstream companies such as Enterprise Products Partners (EPD) - Get Report are good stocks because the company built ethane and propane export terminals to take advantage of the large amounts of natural gas liquids coming out of the Eagle Ford and Permian basins," Dickey said.

Some major oil producers like Exxon Mobil (XOM) - Get Report are facing headwinds as its price-to-earnings ratio has been above 30 and the SEC is examining their accounting practices, said Michael Berger, a former Raymond James energy analyst and founder of Technical420, a Sarasota, Fla.-based company that conducts research on cannabis stocks.

"Exxon Mobil has edged higher over the last month, but I expect to see the shares trade significantly lower in the near term," he said. "For more than three decades the company had a price-to-earnings multiple in the low to high teens. The SEC investigation comes as the company continues to downplay questions about its lack of assets write-downs, saying it is extremely conservative in booking the value of new fields and wells."

Investors should focus on a company's ability to pay their dividends since interest rates are likely to move higher, Berger said.

"This will not benefit oil and gas companies and I expect to see companies issue guidance on this," he said.