2023 has not been a good year for the oil and gas industry or the renewable industry, at least from an investment standpoint. The S&P 500 is up over 19% year to date. And yet, the energy sector, which includes mostly oil and gas stocks, is down over 7%. Additionally, many prominent renewable-focused exchange-traded funds (ETFs), such as the Invesco Solar ETF, First Trust Nasdaq Clean Edge Green Energy ETF, and the iShares Global Clean Energy ETF, are all down 20% or more year to date.
At first glance, you may be wondering how both oil and gas and renewables are performing poorly. Shouldn't one be doing well if the other is doing poorly? Let's examine the (mostly valid) reasons for the underperformance and why both industries are poised to rebound next year.
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Fundamentals have improved across the oil and gas industry
Even when factoring in this year's decline, the energy sector has more than doubled over the last three years. So, part of this year's underperformance could be a cool-off from an epic run-up.
The sector was crushed in 2020 in response to the industrywide downturn. But a lot has changed since then. Many companies have paid down debt and now have rock-solid balance sheets. Leverage has been a problem in the oil and gas industry since it began. And it's what led to the crash of 2014 and 2015. The improved financial health should help the industry weather the next downturn better than prior downturns. And for that reason, the industry is also more attractive to invest in now than in years past.
Exploration and production costs have come down across the industry. Many producers can now break even at $40 oil, which is a nice margin of safety no matter the cycle. Carbon dioxide equivalent emissions and methane emissions have also come down on a per-unit basis. So, overall, the industry is cleaner and more profitable than in the past.
West Texas Intermediate crude oil, the U.S. benchmark, dipped to a five-year low of just under $70 a barrel in December. However, that's still a level where most companies can do very well. Oil and gas stocks can outperform next year for many reasons. But the simplest would be that oil prices stay around where they are, companies have strong performances, and valuations are too cheap to ignore.
Valuations are already low. For example, ExxonMobil (XOM 0.18%) has a price-to-earnings (P/E) ratio of 9.8, and Chevron (CVX 0.69%) has a P/E of 10.6. For cyclical stocks, P/E ratios should be low during a growth cycle but not super low during a mid-cycle period.
Industry leaders like ExxonMobil and Chevron could simply prove to the market that their cost-reduction efforts, technological advances, and acquisitions are paying off so that they can perform at a high level, even at $70 or even $60 oil. So, without even banking on oil prices recovering, quality integrated majors look like a great value.
And if prices do fall, as they did in 2020, ExxonMobil and Chevron, in particular, have already proven they won't cut their dividends even in a downturn. In sum, the potential rewards outweigh the risks for many energy stocks, especially the high-quality majors. And for that reason, it's an industry worth investing in now.
It wouldn't take much for a recovery in renewable energy stocks
In many cases, the levelized cost of electricity produced from onshore wind and solar is now cost-competitive with combined-cycle natural gas. But gasoline and diesel still dominate the transportation industry and passenger vehicles.
There has to be a return on investment to justify building a utility-scale solar or wind farm, investing in electric vehicle charging networks, or taking on a low-carbon investment in carbon capture and storage, hydrogen, or biofuels. The return on investment shrinks when high interest rates increase borrowing costs.
So, it's natural that the renewable industry has experienced a slowdown. Since many renewable stocks are based on their future performance (growth), not their present performance, the sell-off has been brutal for many individual stocks, such as Enphase Energy (ENPH 0.86%) and SolarEdge Technologies (SEDG 2.69%).
On top of this challenge, Russia's invasion of Ukraine shifted the short-term focus away from long-term climate targets and toward energy security. For example, Germany turned to building infrastructure to support importing natural gas (in liquid form) from sellers overseas to make up for the gas it used to get from Russia.
Although oil and gas are reliable, they aren't a long-term solution for the energy transition. Once interest rates cool off, it will be easier for investors to think more long-term about the industry, which could help equity prices of many downbeaten renewable stocks.
Be aware of what's driving the market
Oil and gas and renewable energy stocks are down for different reasons. But both sell-offs illustrate the importance of market sentiment and how it can impact equity prices in the short term.
In years past, investors and Wall Street got burned time and time again by the oil and gas industry. A refusal to accept that the industry has changed and should be less cyclical going forward is keeping a lid on the valuations of even the industry's best companies.
Overly focusing on interest rates and geopolitical tensions caused a massive sell-off in renewable energy. But nothing has changed about the long-term investment thesis and the multidecade tailwind the energy transition will provide to the industry.
No one knows whether oil and gas or renewable stocks will rebound in 2024. But both industries are worth exploring, especially oil and gas for value- and income-orientated investors and renewable energy for growth investors.
