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Why energy stocks could ‘continue to escalate’ going into 2023: Analyst

Tortoise Portfolio Manager Rob Thummel joins Yahoo Finance Live to discuss the outperformance of energy stocks, valuations and dividends, the move in oil prices, oil companies' participation in the energy transition, and the outlook for energy names.

Video Transcript

JULIE HYMAN: Well, energy has been the best performing sector this year amid concerns about oil demand, geopolitical risks, and also the oil companies just having more profitable businesses. Joining me now to weigh in on the energy outlook for 2023 is Tortoise Portfolio manager Rob Thummel. He's here with us in the studio.

Rob, it's good to see you here. And if you look at how those energy stocks have done now for the past couple of years, we've seen this run that they've been on. Yes, there's been the oil dynamics of the underlying commodity, but what has changed for oil companies themselves operationally, if anything?

ROB THUMMEL: Well, it's a really good question. So what's happened is, so the past 10 years, the oil sector basically was re-investing all their profits by just drilling more oil wells and just growing their production. And the energy sector was the worst performing sector in the last decade. Around COVID time, the sector really made its change, a pivot, 180 degree pivot. Decided to be more capital disciplined and actually start returning cash to shareholders.

So the sector now sits in a situation where, for the last two years, it's basically decided, stop spending money, basically, and start returning money, free cash flow, to the investor, whether it's through dividend yields or stock buybacks or debt reduction. Well, what's happened? Well, the sector, for the last two years, has been the best performing sector in the S&P 500, and this year, obviously, delivering really positive returns, which is really hard to find.

JULIE HYMAN: Yeah.

BRIAN SOZZI: But could these stocks continue to outperform next year? If you have oil still trading, what, between $70 and $80, at some point, these stocks have to correct, no?

ROB THUMMEL: Yeah, well, so they're still cheap if you look at it on most metrics. So free cash flow yield is really-- so the market is really rewarding companies that have earnings, positive earnings, and free cash flow. And that's what this sector has. So the free cash flow yield for the energy sector is still double digits. The free cash flow yield for the S&P 500 is still 5%. So there's still room to run there.

From an enterprise value to even just traditional investment metrics, the sector's really not expensive. It's really cheaper than it has been historically as well. So I still think there's room for it to continue to escalate, even if oil prices stay the same or even fall a little bit.

BRAD SMITH: Does the cost consciousness at the company level mean that we're going to continue to kick the can down the road or push out timelines for some of the clean energy transitions, even, that we've heard some of the oil companies try to talk about, or at least, position around?

ROB THUMMEL: No, that's a good question. So I think-- the other thing, I think, that's helped the stocks a bit is a lot of these energy stocks have actually embraced the energy transition. Historically, they had resisted the energy transition. But now they've embraced it a bit.

But to your point, companies like Exxon are going to spend some money on carbon capture, right, in large scale. And I think that's really important for a lot of energy companies. There's a lot of other things going on with hydrogen, carbon capture, or battery storage that the energy sector can participate in. And I think that will help boost their long-term value as well.

JULIE HYMAN: I guess the question is, can they keep performing as they've been performing over the past couple of years? I mean, stocks don't just keep going up because they're cheap, for example, right? There has to be some reason for people to want to buy them. I mean, you also have the idea that energy stocks have done very well while oil has now come down. So is the next move upward actually going to be in the commodity, and maybe the stocks are not going to keep pace?

ROB THUMMEL: Quality always has an impact. I think probably the biggest driver for energy stocks going forward is the dividend yield they offer investors, right? If you talk to strategists-- and I'm not a strategist. I'm an energy person, but they probably are going to tell you, the market's going to go up, what, maybe 7%, 8% next year. Well, in the energy sector, you can find a lot of stocks that you can get 7% or 8% dividend yield. So you're already met the market return from just the cash dividend yield you're going to get from the energy stock you invested.

JULIE HYMAN: I do wonder, though. I mean, we have people coming on here talking about fixed income now a lot. Everybody loves fixed income. So aren't you going to see more of that yield competition going into 2023? Because for the past decade, you couldn't get that yield anywhere else. Now you can. There's more competition.

ROB THUMMEL: That's very true, Julie, and you're right that there is more competition. The unique thing about energy sector is because there's that free cash flow yield, they can actually increase-- they're increasing their dividends to the shareholders. So that's the unique aspect of energy equities versus fixed income. And obviously, it's not going to increase its dividends.

JULIE HYMAN: Right.

ROB THUMMEL: Oh, interesting.

BRIAN SOZZI: Rob, the general consensus is that the China economy is close to fully reopening by the spring of next year. If that happens, are oil prices back over $100?

ROB THUMMEL: I hope not $100, but I do think they go higher. I mean, right now, China is driving oil prices. And so what we've seen, obviously, is the concern about the China reopening being delayed, obviously, has really reduced oil prices in general. And Chinese demand, which has grown, really, almost every year for several decades, is actually going to be negative growth this year.

So when that growth returns, you're going to have oil prices probably go higher because what a lot of people aren't talking about is oil inventories around the world are very, very low. They're well below historical levels. And they've got to be refilled at some point in time. And so-- and whether that's in the US with the SVR, or globally, or even in places like large consumers like China. So you're going to see more and more demand going forward for oil. And there's just not a lot of extra supply coming online in the next several years.

BRAD SMITH: In the US, we had tapped reserves. Is there any clear indication that that was an effort that worked ultimately, or that the end consumer was able to see a net difference?

ROB THUMMEL: Well, you've seen gasoline prices come down a lot. When we started reducing the Strategic Petroleum Reserve in the US, was in the summertime, and oil prices were $115, $117 a barrel. And today, they're 77. You know, gasoline prices were above $5 a barrel, and today they're below $3 on a nationwide average basis. So yeah, it did have a positive impact.

JULIE HYMAN: All right, thanks so much for coming in, Rob. Good to see you. Rob Thummel of Tortoise-- Tortoise. Is it just called Tortoise, or is there more--

ROB THUMMEL: Tortoise Capital, that's fine.

JULIE HYMAN: Tortoise Capital portfolio manager. Thank you so much. Appreciate it.