Sujata Rao and Danilo Masoni

MILAN/LONDON – The return of big oil.

Fund managers are once again attracted to cash-rich oil companies after enduring near death during the COVID crisis, when demand dropped and becoming distinctly out-of-trend with the sustainable investing wave that engulfed Wall Street.

The MSCI World Energy Index is on the verge of its strongest run since 1998. It has risen more than 40% in just 2021, thanks to oil’s strong rally.

It’s possible that there will be more: The International Energy Agency expects oil demand to return to pre-pandemic levels around 2022. Additionally, the Index trades at an almost 4-to-1 valuation discount to its broader counterpart.

The equity gains so far have also lagged the 60% crude rally https://tmsnrt.rs/3jlFIAv, and analysts believe there could be catch-up potential from now on, even if crude stabilises.

An 16-year high is expected for earnings optimism. Profits for oil firms in Europe, the U.S. and elsewhere should rise 720% to 43billion euros each and 1,300% respectively to $68 billion — highest sector according to Refinitiv i/B/E/S.

Graphic: Energy stocks profit optimism: https://fingfx.thomsonreuters.com/gfx/mkt/klvykzmabvg/Energy%20stocks%20profit%20optimism.PNG

But the real question here is: What do management teams do about those earnings?

Contrary to previous price booms many oil companies seem reluctant increase their investment in upstream production. Instead, the IEA requested that this month see a significant increase in investments in renewable energy to meet future demands.

Kiran Ganesh of UBS Global Wealth Management’s multi-asset department said that the hesitation to invest in traditional sources of energy was a result of ESG (environmental social and governance), which emphasizes sustainability.

“Historically when oil prices rose, we’ve seen increases in investment. “This time the answer has not come through, because companies are more interested in redistributing shareholders via buybacks and dividends,” he stated.

It’s good news for investors but not for those who are hoping for moderate commodity prices.

Investments in oil and natural gas could reach as low as $365billion this year. Morgan Stanley Rystad Energy, a data provider of information said that (NYSE:). This is compared to the $475 billion that was spent in 2019 and $740 million in 2014.

European oil companies, such as BP and Royal Dutch Shell (NYSE:), have spent billions of dollars in order to lessen their dependency on petroleum and increase their emphasis on renewables. Morgan Stanley’s analysis of 120 oil companies shows that total capex is at an all-time low, even for 2023. These figures also include investments in renewables. This suggests that there will be a flat or declining oil and gas supply, and they expect to see a peak around 2024.

BofA Securities’ October survey of managers of funds found that commodities had the largest consensus overweight. Nearly 50% of respondents predicted that oil prices would surpass $100/barrel.

Graphic: Energy stocks have lagged oil: https://fingfx.thomsonreuters.com/gfx/mkt/jnvwewlnevw/Energy%20stocks%20lag%20crude%20oil%20rally.PNG

“DIVIDENDS MATCH THE BILL!”

Oil companies have a wealth of cash flows, and many are rewarding shareholders for their profits.

Refinitiv data shows that Europe’s energy sector is second in terms of free cash flow, while the global index for energy has a comparable measure hovering around a 35-year peak.

Since January 2019, the MSCI Energy’s dividend yield has been at 4.7%. It is the largest among all the MSCI sector sectors. Now, it is at 4.7%.

JPMorgan (NYSE ) predicts that European oil majors could return 20% of the market capitalisation they have by 2023. They also believe future earnings might provide an opportunity for certain stocks.

Bernstein strategists Sarah McCarthy & Mark Diver are overweights for the sector in the “long and short-run”, with an average dividend yield and buyback yield at 8%.

According to them, dividends would be a suitable option for investors in an environment of negative real yields and moderately higher inflation where they need access real income streams.

Graphic: Energy offers the highest yield: https://fingfx.thomsonreuters.com/gfx/mkt/klvykzbgqvg/Energy%20offers%20the%20highest%20dividend%20yield.PNG

Since March 2020, the sector has seen money flow back to it.

Holdings of the iShares Global Energy ETF NYSE: Exxon Mobil (NYSE:). Chevron (NYSE:) TotalEnergies and BP — set records for trading volume in the third quarter.

Last year, when crude oil futures plummeted below zero, the turnaround of oil stocks seemed unlikely.

Angelo Meda from Banor SIM Milan, Portfolio Manager, said that oil was viewed by markets as an inherently secular commodity. People were beginning to be concerned about the risks of winding down facilities or sunk costs.

He stated, “There is still plenty of room (for oil stock) to grow further once it becomes obvious that crude demand doesn’t quite reach its peak. I think we’ll get there somewhere around the end-of this decade.”

Graphic: Energy stocks valuation discount: https://fingfx.thomsonreuters.com/gfx/mkt/zdpxorazmvx/Energy%20stocks%20valuation%20spread%20vs%20market.PNG