Stocks have enjoyed a rebound rally in recent weeks — the S&P 500 Index is up 15 percent from the low in early October. Many global equity markets have followed suit, but recent gains in global equities are nothing compared to the upward surge in crude oil prices.¹

Oil prices rose to the highest level in more than three months with West Texas crude up nearly 30 percent since early October.²

Surging oil prices could be good news for equity investors since the two markets have been tightly correlated in recent months. In other words, as oil prices rise, stock prices tend to follow.

It makes sense why an important global commodity like oil should be influenced by the outlook for economic growth. As growth prospects recede, demand for oil and gas also tends to retreat. The chart (below) from the US Energy Information Administration (EIA) illustrates this correlation.

The opposite is also true, as rising economic growth leads to increased demand for crude. The same pattern generally holds for the S&P 500 Index. A stronger economy translates into better earnings growth, propelling share prices higher.

Of course, crude oil and stock prices don’t always follow in lockstep. In early 2011, the two markets had a negative correlation. This anomaly occurred as tensions rose in the Middle East and North Africa in the spring, sending oil prices higher while stocks corrected.³

During the second quarter, the two markets fell back in line, however, with a 56 percent positive correlation as both markets drifted lower more or less in tandem. Correlation strengthened significantly in the third quarter as both oil and stocks initially sold off, but since the end of September, both have rallied sharply with crude oil prices taking a big lead.⁴

Are Stocks Playing Catch-Up with Bubbling Crude?

Crude’s move higher may indicate the global economy is in better shape than some believe and that growth is on the upswing again, along with demand for oil and gas. It could also be telling us that stocks have further room to move higher, playing catch-up with soaring crude prices. After all, crude oil and the S&P 500 have had a positive correlation in 12 of the past 13 quarters. Time will tell.⁵

According to the latest data from the International Energy Agency (IEA), demand for energy is expected to surge by one-third over the next two decades, driven mostly by emerging markets.

Incrementally, emerging markets already account for a big share of economic growth today, and these countries will account for 70 percent of increased economic output over the next 20 years, according to the IEA.⁶

At the same time, emerging markets will account for 90 percent of the increase in energy consumption over that same period. As a result, crude oil demand could increase from about 90 million barrels per day (mb/d) last year to almost 110 (mb/d) by the year 2035.⁷

Despite lingering headwinds from the 2008 financial crisis, a severe recession, and ongoing deleveraging; we have witnessed a persistent upswing in oil prices, which appears to be a longer-term secular trend that may continue for years.

Profiting from This Key Secular Trend

Given the strong fundamental trends listed above, the energy sector of the S&P 500 Index is experiencing very robust profit growth and has been one of the best performing sectors despite erratic market activity.

Earnings for energy companies in the S&P 500 surged 58 percent higher during the third-quarter of 2011, over the same period one year ago. That is far and away the best profit growth registered by any of the 10 broad S&P sectors. By comparison, overall S&P 500 earnings increased a robust 17.8 percent in the third quarter.⁸

During the month of October, energy sector stocks were likewise among the top performing sectors in total return, up nearly 17 percent for the month compared to a gain of 10.8 percent for the S&P 500 Index. In fact, energy stocks are also the top performing sector over the last one-year period ending October, in spite of sharp up and down swings in many other sectors.⁹

At Banyan Partners, we see good opportunity in the energy sector. However, rather than buying a diversified basket of energy stocks, we prefer a more targeted approach, making key selections among the drillers, integrateds and exploration companies based on our clients’ specific risk tolerances and time horizons. We’ve written previously about the long-term profit opportunities we expect in this sector (Issue 23 – June 29, 2011). More recently, we increased our allocations to the energy sector in our Banyan core equity portfolios, boosting this sector to an overweight position relative to the S&P 500 Index.

Strong third-quarter financial reports from energy firms, combined with bullish long-term demand trends are enough to convince us of the investment potential for this sector. Case in point is Conoco Phillips (NYSE: COP), the third largest US oil & gas producer reported better-than-expected third quarter profits of $2.6 billion. Earnings from their refining and marketing business nearly tripled from a year ago, helped by higher profit margins.¹⁰

Likewise, Devon Energy (NYSE: DVN) an industry leader in unconventional oil and gas production, posted a 25 percent increase in top-line revenue in the third quarter thanks to increased production. Devon also has a solid balance sheet with $6.8 billion in cash and equivalents, plus the company generated $1.9 billion of cash flow last quarter alone.¹¹

Bottom line: Crude oil and stock prices appear to be enjoying a tight upside correlation in recent performance. What’s more, the upward move in both markets is a strong indication of an improving economy, in our view.

According to the most recent IEA data, crude oil inventories fell by 800,000 barrels per day over the past two months, more than twice the normal rate at this time of year, signaling tight market conditions in the near term. Meanwhile, long run, global supply/demand imbalances tell us this secular trend toward higher energy prices is intact, which should provide fuel for energy stocks to continue outperforming.  

Good investing,

Mike Burnick
Director of Client Communications
Banyan Partners, LLC

---

¹ Bloomberg market data, 11/14/11
² Ibid.
³ US Energy Information Administration, 10/24/11
⁴ Ibid.
⁵ Ibid.
⁶ International Energy Agency: World Energy Outlook, 11/9/11
⁷ International Energy Agency: World Energy Outlook, 11/9/11; US Global Investors, 11/11/11
⁸ Standard & Poor’s as of 10/31/11
⁹ Ibid.
¹⁰ Reuters: Conoco profit tops street on refining strength, 10/26/11
¹¹ Devon Energy, 11/2/11