Oil Has Plenty Of Room To Run

Energy stocks are absolutely soaring in 2022. Year-to-date, the S&P 500 Energy Index has risen 38%, compared to a 5.6% decline for the S&P 500. A number of factors have come together to create a perfect scenario for oil & gas stocks this year. First, we have the ongoing economic recovery from COVID-19, which has increased demand for travel. Second, there is the war in Eastern Europe, which has destabilized the world’s oil supply. So we’ve got strong demand and weak supply – a recipe for higher oil prices.

It shouldn’t come as any surprise that energy stocks rallied in this environment. Companies that extract and sell oil make more revenue when the price of oil rises. They generally earn more profit, too (depending on costs). As a result, oil stocks tend to correlate strongly with the price of oil–no big surprises there.

So we’ve got bullishness in oil that’s leading to bullishness in energy stocks. That all makes perfect sense, but it still leaves open the question:

Where does the price of oil go from here?

For oil stocks to keep delivering alpha, oil prices will need to be at least “relatively strong.” It’s not a perfect 1.0 correlation; an oil company can earn higher profits on flat oil prices by cutting costs, or by selling more product. But generally speaking, there is a positive and strong relationship between oil prices and energy stock prices, as I’ll demonstrate shortly.

So for energy stocks to keep rising, we will need oil prices to stay relatively high. That’s not to say that oil prices have to keep rising–there’s a strong case to be made that even $90 oil isn’t priced in yet. But a total collapse in oil prices would likely be felt in energy stock prices eventually.

It’s for this reason that I sold my sole energy play this year relatively early. Feeling that the rise in oil prices wouldn’t continue much longer, I exited Suncor Energy (SU) at a 10% gain. Since then, I have revised my stance on energy stocks, mainly because I don’t believe even $90 WTI has been priced in to stock prices yet. In this article I will make the case that oil is likely to remain above $90 in 2022, and that energy stocks most likely still have room to run from here on out. I will start by exploring the relationship between oil prices and energy stocks, then move in to a forecast of oil price levels for the year ahead.

Oil Prices and Energy Stocks: a Regression Analysis

Before knowing how oil prices are likely to behave, we need to know the relationship between oil prices and energy stocks. Energy companies generally make more money when the price of oil rises, but the impact of oil prices on stock prices is less clear. A broad market selloff with massive ETF outflows could cause the correlation between oil and energy stocks to weaken. So, we need to know exactly how strong the statistical relationship is.

We can gauge how much oil prices influence energy stock prices by doing a simple linear regression, with oil prices as the independent variable and energy stock prices as the dependent variable.

For this analysis, I’ll use WTI Oil prices (the barrel most relevant to North American companies) and the S&P 500 Energy Index Level. Measurement period will be the first quarter of 2022, with Sunday closing prices for WTI futures and the following Friday’s prices for the S&P 500 Energy & Equipment Index.

The raw data are as follows:

	WTI	Energy Index
Week 1	78.9	232.06
Week 2	83.82	250.35
Week 3	85.14	242.31
Week 4	86.82	261.81
Week 5	92.31	257.87
Week 6	93.1	273.95
Week 7	91.07	269.74
Week 8	91.59	268.56
Week 9	115.68	278.23
Week 10	109.3	308.33
Week 11	104.7	289.50
Week 12	113.9	316.55
MEAN	95.52	270.77
SUM	1146.33	3249.26

From this we can get some useful statistics:

• WTI variance: 151.48.

• Energy stocks variance: 627.38.

• Covariance: 271.27

• Correlation: 0.88.

From the looks of it so far, we have a fairly high correlation between WTI and energy stocks, suggesting a relationship. But we need to do a linear regression to really confirm that a relationship is at play here.

We can set the null hypothesis as that there is a 0 relationship between WTI prices and energy stock levels.

The alternative hypothesis is that the relationship is greater than 0. So, my hypothesis is not only that there is a relationship, but a positive one.

The results of my regression analysis done in Excel are shown below:

WTI to Energy Stocks Regression Analysis
Regression Statistics
Multiple R	0.87992856
R Square	0.77427427
Adjusted R Square	0.7517017
Standard Error	12.4810881
Observations	12
ANOVA
	df	SS	MS	F	Significance F
Regression	1	5343.41196	5343.41196	34.3015511	0.00016014
Residual	10	1557.77561	155.777561
Total	11	6901.18757
	Coefficients	Standard Error	t Stat	P-value	Lower 95%	Upper 95%	Lower 95.0%	Upper 95.0%
Intercept	99.7101037	29.4289674	3.38816182	0.00690715	34.1382781	165.281929	34.1382781	165.281929
X Variable 1	1.79070491	0.30575048	5.85675261	0.00016014	1.10945039	2.47195943	1.10945039	2.47195943

As you can see, the computed F statistic exceeds the critical value, and the P value is small. I used a 95% confidence level here, so we can reject the null hypothesis that there is no relationship between WTI and Energy Stocks with 95% certainty.

Where Oil is Headed

Having established that there is a very strong relationship between oil prices and energy stock prices, the next logical question is, “where is the price of oil headed?” We’ve seen oil prices rally dramatically this year, but there has been significant volatility. This hasn’t exactly been a smooth and predictable ride upward.

Of course, the war between Russia and Ukraine has played a big role in oil’s climb. Concerns about Russian supply being cut off have led to buyers bidding up oil in the futures market. Russia still sells oil to EU countries, but it appears that buyers are bidding up oil in anticipation of a future supply crunch. Additionally, Russia’s actions in Ukraine have at least slowed the flow of oil out of Eastern Europe. Early in the war, Russia blew up a Ukrainian gas pipeline. More recently there have been concerns about Russian troops’ presence at gas compressor stations. So there is some level of supply shock already happening, and a significant amount of betting that the shock will get worse.

When the conflict in Eastern Europe ends, it’s possible that the price of oil will fall. It’s no guarantee: oil prices topped $90 on February 11, several weeks before Russia’s troop buildup was even in the conversation. But it would be wise to prepare for a scenario where it does happen.

Given that I calculated a 0.88 correlation between oil prices and energy stocks, it’s quite likely that energy stocks would fall if WTI prices fell to $90. However, a 0.88 correlation isn’t a 1.0 correlation. It’s possible for oil stocks and oil prices to diverge.

And indeed, there is some basis for thinking that they will. Prior to this year, the most recent period in which oil prices regularly topped $90 was in 2014. For most of 2014, the energy index level was double what it is now. If markets were valuing energy stocks accurately in 2014, then oil stocks may be undervalued today, even with WTI ticking below $100.

Some Oil Stocks to Research

As we’ve seen, oil stocks still have plenty of room to run in 2022. It’s no guarantee that they will do so, but the odds are fairly high. Supply chains are still disrupted and the war in Ukraine is nowhere near over. We’d expect relatively high oil prices.

If you’re looking for oil stocks to research, I have two suggestions:

The first is Suncor Energy. This is an oil play I myself made earlier this year. I exited a few weeks ago but I still think it’s a decent dividend play.

Suncor is an integrated energy company whose two main business activities are selling gasoline at the pumps, and exporting oil to the United States. Its most recent quarter was quite strong. It technically missed analyst estimates, but funds from operations grew 157% and net income swung from a loss to a $1.55 billion profit. That was for the fourth quarter, when oil prices were only hovering around $70. For the first quarter, oil was usually above $100, so earnings could easily surpass $2 billion. Yet SU stock is still quite cheap, with a 1.6 price-to-book ratio and a 5 price-to-operating cash flow ratio.

The second is Kinder Morgan (KMI). It’s a pipeline with a 5.71% dividend yield. The thesis on this one is different from that of Suncor. Whereas you’d buy Suncor to play higher oil prices, you’d buy KMI as an energy play that can withstand low oil prices. Pipelines don’t directly sell oil; they collect toll fees to transport it. So, their earnings don’t swing downward as badly as those of integrated energy companies when oil prices fall. Pipelines are well known for their high dividend yields, which attract many income investors. Unfortunately, some of these stocks sport truly outrageous payout ratios, well over 100%. KMI, with its 81% payout ratio, appears to be a bit more sustainable than its sector. Its 42% year-over-year revenue growth and 1.4 price-to-book ratio don’t hurt, either.

The big picture is this:

Whether you choose an integrated energy company like Suncor or a pipeline like Kinder Morgan, the opportunities in oil and gas stocks are still there. The pickings aren’t ripe as they were last year, but the economics are still solid.