Energy funds are leading again, but the war in Ukraine makes the future uncertain

The wild ride in energy markets shows no sign of abating. After topping the charts in 2021, funds investing in energy stocks were again the strongest performers of any sector in the first quarter.

However, some investors are wondering how long this phase can last amid mounting uncertainty as European leaders debate halting Russian imports and sanctions, inflation and the pandemic threaten global growth.

“I don’t think I would increase exposure to energy right now,” said John Maloney, chairman of M&R Capital Management, a New York-based wealth management firm. “Stocks may have more lift, but you don’t need to catch every last dollar of profit.”

Energy funds gained 32 percent in the first three months of the year, by far the highest return of any sector. In 2021, as demand recovered from the depths of the Covid-19 pandemic, energy stock funds gained 40.9 percent, compared to the S&P 500’s 26.9 percent rise.

As is so often the case, energy company stocks have been guided by oil prices. Brent crude, the closely-watched global benchmark, rose to an intraday high of nearly $140 a barrel on March 7 – the highest since 2008 – as the United States prepared to ban Russian energy products from entering the country . It has since settled closer to $100 a barrel, and the US Energy Information Administration forecasts it will trade at an average of $105 a barrel this year, well above the $71 average in 2021.

European Union leaders continue to discuss how quickly and how much they can reduce their dependence on Russian energy. But even without a total ban on Russian energy in Europe, many companies have backed away from it. “Buy from Russia has a scarlet letter attached,” said Tom Kloza, global head of energy analysis at Oil Price Information Service. This could lead to higher oil prices worldwide.

EU leaders have also announced ambitious plans to buy more LNG from US producers. Even before Russia invaded Ukraine — and Russian President Vladimir V. Putin threatened to turn off the tap if countries didn’t pay in rubles — low natural gas supplies and record prices in Europe prompted US producers to ship more gas there . European LNG imports from the United States hit a record high in December, which has since been surpassed in January and February.

But there’s a catch. The United States, the world’s largest energy producer, doesn’t have much spare capacity in either oil or gas.

“The impediment to many Gulf Coast LNG projects has not been government approval, but a lack of financial support,” said Jason Bordoff, founding director of the Center on Global Energy Policy at Columbia University. “But Europeans have signaled that they intend to sign more long-term contracts for LNG supply, which should help these projects make final investment decisions.”

It’s not just financiers who are reluctant to fund new exploration and production. Shareholders have claimed a bigger chunk of the gains after years of miserable investment returns for energy funds. A typical investor who bought an energy stock fund five years ago would have recently broken even, according to the Morningstar Direct. As a result, the energy industry has focused on shareholder returns rather than pouring profits back into their businesses, a strategy markets have dubbed capital discipline.

“Capital discipline isn’t just about what fields are being drilled in,” said David Lebovitz, global market strategist at JP Morgan Asset Management. “The new approach goes to the profitable fields and drills five to seven wells instead of ten. If you’re an energy company, you don’t want to overwhelm the world with oversupply.”

Among the portfolios Mr. Maloney manages for clients is the exchange traded fund Vanguard Energy. This $8.3 billion fund returned 39 percent in the first quarter after a 0.1 percent management fee. Exxon and Chevron are the two largest holdings, with a combined weighting of 38 percent. Exxon shares rose 36.5 percent in the first three months of the year; Chevron shares rose 40.1 percent.

Chevron has suspended sales of certain chemicals and consumer products in Russia and says it has no exploration or production operations there. It has a 15 percent stake in an oil pipeline that carries crude oil from Kazakhstan to a Russian Black Sea terminal, where deliveries continue uninterrupted. There, Kazakh oil can be mixed with Russian crude, although Chevron has said its “efforts are being conducted in accordance with US law.”

Exxon, which has done much more business in Russia, announced on March 1 that it was leaving the country and not making any further investments there “given the current situation.” It had operated a major exploration project in Russia’s Far East known as Sakhalin-1.

Mr Maloney said he viewed energy stocks primarily as a hedge against other holdings that could move in the opposite direction, such as airlines, trucking companies and other companies sensitive to fuel prices, after share prices rose last year.

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