Energy sector

While energy stocks have had a slow 2023, I believe 2024 could be bright, thanks to continued high oil prices and rising investments in energy production. Among the potential beneficiaries: oil producers and energy equipment and services companies.

Crude oil prices are likely to remain elevated in 2024—driven by tight supply, increased geopolitical risk, and strengthening global demand for energy. This could set up a positive backdrop for profitability, and potentially stock prices, in the sector. A wave of new investment in international and offshore production has also contributed to that positive outlook, and has created a particularly compelling setup for energy equipment and services companies.

Energy stocks took a breather in 2023

After leading the market by an enormous margin in 2022, when energy was the top-performing sector, these stocks have pulled back. The sector had lost 6.7% as of mid December, compared with the nearly 20% gain for the S&P 500^®.

In part, that slower performance was due simply to a shift in investor preferences—with investors favoring tech stocks and other high-growth sectors for most of 2023 (those sectors are seen as benefiting from slowing inflation and slowing interest-rate hikes). And in part it's been due to fears of an economic slowdown, which could threaten energy demand and pressure commodity prices.

Oil prices could stay high

That said, I think the outlook for energy stocks is promising. That's in no small part due to the likelihood that relatively high oil prices might persist. For example, the price of Brent crude oil—a light crude oil that is extracted from the oilfields in the North Sea—started the year at about $77 per barrel, then hit a high of $94 in late September before settling at about $75 as of mid December. At these levels, the price of crude oil allows most oil and gas companies to be quite profitable.

Several factors at play are helping to constrain the supply outlook for oil, which should help continue to support prices. Global investment in oil production has remained low for nearly a decade. Though investment is increasing, it will take several years for most of the new supply to come online.

In the U.S., shale oil production may see slower growth going forward, given rising production costs and the maturity of shale-producing regions. Looking abroad, the Organization of the Petroleum Exporting Countries (OPEC), a cartel of leading oil-producing countries, is keeping a tight rein on supplies. The group agreed last spring to reduce output through 2024, and member nations Saudi Arabia and Russia announced that they were voluntarily cutting production by even more than what the cartel had agreed to. OPEC is likely to keep oil supplies in check as it seeks to maintain per-barrel oil prices in the $80 to $100 range—considered the sweet spot that delivers strong profitability to oil producers without hurting demand for oil. Another factor is elevated geopolitical risk, with 2 major wars currently underway that could threaten global oil supplies.

Meanwhile, global demand for oil is solid. I expect it to grow in 2024, thanks to China's ongoing economic recovery and growth in India and other developing economies. Looking out beyond 2024, economic growth in developing markets is likely to drive further increases in oil demand.

That potential combination of growing demand and constrained supply could continue to support energy prices.

What to watch: Energy equipment and services stocks

Looking across the sector, I believe energy equipment and services companies could be well positioned in 2024. These are the companies that provide the essential equipment and services to produce oil and gas, such as the rigs, crews, and technology needed to drill and complete a well. This is an industry that I believe could benefit from multiple years of growing investments needed to support rising demand for oil and gas. Further, I believe many investors may be underestimating the level of investment needed to meet the world's growing demand for energy commodities.

The years-long trend of low investment in new oil and gas production, particularly in international and offshore markets, has already begun to reverse course. However, new production can take a long time to ramp up, and so it typically takes several years for international and offshore spending to recover. I believe the industry is still in the early innings of a significant investment cycle in international and offshore production. Corporate spending has been increasing and is likely to continue to grow.

As oil producers seek to boost investment in production, they boost spending on energy equipment and services. Moreover, oilfield services firms may have an advantage in strong pricing power—due to tight capacity in many industry subsectors. The oilfield services industry is known for its high incremental profit margins, which means that when demand and pricing are strong, earnings can potentially grow rapidly.

Outlook is bright

Energy is a competitive, capital-intensive sector that tends to rise and fall with the broader economy. I prefer to invest in companies that can generate competitive returns on capital but trade at discounted valuations, and those that have some sort of competitive advantage, have healthy or improving balance sheets, and that take a disciplined approach to capital allocation.

There are many energy companies with these attributes and, given the sector's favorable business conditions and reasonable stock valuations, I believe the outlook for energy in 2024 is promising.