How Will Energy Stocks Respond to This Earnings Season?

By the time you read this, it is likely that the two largest American oil companies, Exxon Mobil (XOM) and Chevron (CVX), will have reported their calendar Q1 results, due out on Friday morning. We cannot know at this point exactly what they will say, but based on analysts' estimates we can be pretty sure that both will report EPS that is significantly less than they showed in the same quarter last year. That is a dynamic that is expected to apply to most of the energy sector, and yet, as this chart for the SPDR Energy sector ETF (XLE) shows, energy stocks are significantly higher now than they were a year ago.

On the surface, that makes no sense. How can energy stocks be higher when profits are anticipated to be so much lower than a year ago, around 23% down for XOM, for example, and minus 20% for CVX?

The answer is fairly obvious when you look at a chart for oil over the last year…

…crude is higher than it was a year ago. While WTI has pulled back slightly recently, that comes after a strong four-month uptrend. Stocks in general are more about discounting the future than pricing in the past, so oil stocks are higher based on the assumption that higher oil prices will translate to higher future profits.

That all makes perfect sense, but there are potentially a couple of issues here.

First, it all rests on the assumption that oil prices will at least remain at these levels, if not move higher. If you have been reading what I have written over the last couple of months, you will know that I believe that to be true. Nor am I the only one. As this article at Oilprice.com says, Standard Chartered analysts have concluded that oil demand will pick up over the next couple of months, resulting in a significantly tighter market. However, that all also depends on interest rates around the world, and with the Fed seeming increasingly reluctant to cut any time soon, that could introduce some doubt about demand. Over the next few days, as big oil companies report, they will give their views. Should they have a slightly less positive view than do I and Standard Chartered, their stocks could get hit hard.

There is, then, clearly some downside risk over the next few weeks, but overall, the outlook for energy stocks remains bullish.

Demand has remained quite high despite big rises in prevailing interest rates, China, the world's biggest oil importer, is bouncing back, OPEC+ is still restricting supply, and the Middle East is in chaos. All of that will keep oil elevated for a while which should be reflected in oil stock prices, but even if oil simply remains steady for a while, there is an argument for why energy stocks will climb after this earnings season.

The current trailing P/E ratio of XLE is just below 9. That is much lower than the broader market but, more significantly, also well below the long-term average earnings multiple for the fund itself. There are two ways that that ratio can revert to the mean. Either earnings have to fall more than anticipated, or stock prices have to rise. Given the elevated oil price and strong demand outlook, the first of those looks unlikely, leaving an increase in stock prices as the most likely path over the next few months.

So, while energy stocks are higher right now than they were a year ago on profits that are lower, there are several factors pointing to a positive reaction to earnings, almost whatever they are. There are still risks, so buying aggressively before earnings is probably not the best strategy, but nor is selling. Rather, waiting to make sure that there are no big surprises in terms of forward guidance and then buying if there are not is a sensible strategy on the basis that the price of oil, global growth, and a reversion to the mean in terms of P/E all point to long-term appreciation in energy stocks.