Can you guess which is the top performing sector of the S&P 500 was in 2021? Was it the technology, which has outperformed the past decade? No. Health, as companies seek to combat COVID-19 and its variants? Think again.
No, the best performing sector was the energy sector, up about 48% through Dec. 29, compared to a 27.6% gain (excluding dividends) for the S&P 500, according to Yardeni Research.
This may be surprising, given concerns about climate change and the emergence of the delta and omicron variants this year. Yet traditional energy has been lagging behind the market for years, so it took a turn in 2021.
As we look to 2022, here’s why the big energy movement might just be the start of things to come.
Omicron should be gone in time for the summer season
After a big rally, oil prices have fallen recently due to the emergence of the omicron variant. It’s no surprise that if omicron is better at evading vaccines, we could envision a situation in which more and more people are isolating themselves and not traveling.
Still, there is reason to be optimistic. Recent data from London, one of the first major cities outside South Africa to experience the omicron wave, shows cases may peak, with the seven-day average flattening in recent days.
More importantly, hospitalizations and deaths, while on the rise, are still well below levels seen last winter. This suggests that omicron is less severe and that current vaccines and treatments offer significant protection. Meanwhile, the Food and Drug Administration (FDA) recently approved antiviral pills for COVID from both Pfizer and Merck & Co., adding to the arsenal of treatments for serious illnesses.
And despite omicron, the US economy and labor market remain strong. The recent number of jobless claims continues to hover around its lowest level in 52 years as the United States has managed an incredible comeback from the pandemic.
With the US economy so strong and the winter pushes fading, hopefully travel and recreation could pick up. After two years of the pandemic, there is still a lot of pent-up travel demand, so energy demand could remain robust as the world emerges from the latest variant.
Still, supply could remain limited – perhaps severely
Prior to the last few months, we had experienced low oil prices for most of the past decade thanks to the US shale boom. After breakthroughs in hydraulic fracturing opened up vast supplies to the United States, junior shale players pursued a growth-at-any-cost mentality as they sought to cash in.
But that mentality was sabotaging itself, as the growth of the U.S. shale kept oil prices low for years. The combination of low prices and the recent movement of ESG (environment, social and governance) investment has also kept oil exploration lukewarm, even outside the United States. Several oil majors have redirected their investments towards renewable energies to the detriment of further exploration. And of course, that period ended with a sharp drop in upstream investment as COVID-19 became a global pandemic in March 2020.
Even now that oil prices have rebounded sharply, oil companies are still restricting their drilling. After a wave of consolidation, many shale companies have said they will limit production growth to between zero and 5 percent. While not exactly cartel-style coordination, similar numbers given by several management teams all point to a rational market focused on profit and efficiency rather than growth.
But it’s not just shale; despite rising prices, overall upstream investment is expected to amount to just $ 341 billion this year, according to a new report from the International Energy Forum (IEF) and IHS Markit. This is still well below pre-pandemic levels of $ 525 billion. With global demand for oil nearing 2019 levels in November ahead of the omicron start, and with many predicting record demand next year as the omicron recedes, that’s a huge gap to close.
With pressures from investors and politicians limiting supply growth, it is difficult to see upstream investments bounce back to where they need to be in the short to medium term, before renewables reach scale. This should keep oil prices high, with the potential for serious price shocks.
Massive dividends are coming to investors
While supply and demand dynamics can drive oil prices higher, even if prices stay where they are, oil stocks could still be doing well. As I noted, many companies have decided to limit the growth of production in favor of profits. With these profits, oil companies pay massive dividends to shareholders.
High-dividend-paying stocks could find even more favor in 2022, especially if interest rates rise. Higher interest rates could cause investors to discount future profits more and increase short-term costs to consumers. This dynamic would put a premium on stocks with low valuations and higher current earnings today, especially those that pay larger cash rewards to shareholders.
Despite their rise this year, many energy companies continue to pay top dividends to the market. Majors such as Chevron (NYSE: CVX) and ExxonMobil (NYSE: XOM) pay fixed dividends which yield 4.5% and 5.7% respectively.
What about the aforementioned shale companies that limit production? Many have adopted a new variable dividend paradigm, in which they will pay a low base dividend and a higher dividend, which will change from quarter to quarter based on the company’s free cash flow.
Two of the first proponents of this approach are the shale leaders Pioneer of natural resources (NYSE: PXD) and Devon Energy (NYSE: DVN), which has just started paying variable dividends as oil prices soared in the second half of 2021.
In the last quarter, Pioneer paid its fixed dividend of $ 0.56 and a variable dividend in addition to that of $ 3.02, for a total quarterly dividend of $ 3.58 per share. On an annualized basis, this works out to a dividend yield of 7.8% at today’s stock price. And Devon’s fixed dividend of $ 0.11 was supplemented by a variable dividend of $ 0.73 last quarter, for a total dividend of $ 0.84, good for an annualized return of 7.6% over the course of today’s action.
So if the price of oil maintains its current levels, or even dips a little below, energy dividends could attract yield-hungry investors in 2022. And if supply is unable to meet demand, energy stocks would also serve as a useful hedge against potential price shocks. I expect another strong year for the energy sector in 2022.
This article represents the opinion of the author, who may disagree with the “official” recommendation position of a premium Motley Fool consulting service. We are motley! Challenging an investment thesis – even one of our own – helps us all to think critically about investing and make decisions that help us become smarter, happier, and richer.