Energy Funds Lead Again, but Ukraine War Makes Future Uncertain

The wild ride that energy markets have been on shows no signs of abating. After topping the charts in 2021, funds that invest in energy stocks once again turned in the strongest performance of any sector in the first quarter.

But some investors wonder how much longer that streak can continue in the face of mounting uncertainty, with European leaders debating cutting off Russian imports, and as sanctions, inflation and the pandemic threaten global growth.

“I don’t think I would be adding exposure to energy now,” said John Maloney, the chairman of M&R Capital Management, a New York wealth management firm. “The stocks may have more lift to them, but you don’t need to catch the last dollar of profit.”

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

As is often the case, shares of energy companies took cues from oil prices. Brent crude, the closely watched global benchmark, spiked on March 7 to an intraday high of nearly $140 a barrel — its highest point since 2008 — as the United States prepared to ban Russian energy products from entering the country. It has since settled to closer to $100 a barrel, and the U.S. Energy Information Administration forecasts it trading at an average of $105 a barrel this year, well above the average of $71 in 2021.

European Union leaders continue to debate how quickly and how severely to reduce their dependence on Russian energy. But even without a complete ban in Europe on Russian energy, many companies have been avoiding it. “There is a scarlet letter attached to buying from Russia,” said Tom Kloza, the global head of energy analysis at Oil Price Information Service. That could lead to higher oil prices globally.

E.U. leaders have also announced ambitious plans to buy more liquefied natural gas from U.S. producers. Even before Russia’s invasion of Ukraine — and the threat by President Vladimir V. Putin of Russia to turn off the spigot if countries won’t pay in rubles — low natural gas inventories and record prices in Europe were driving U.S. producers to send more gas there. European L.N.G. imports from the United States hit a record high in December that 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.

A liquefied natural gas facility in Port Arthur, Texas. The United States has little additional capacity for sending L.N.G. to Europe.Credit…Martha Irvine/Associated Press

“The barrier to many Gulf Coast L.N.G. projects hasn’t been government permitting but the lack of financial backing,” said Jason Bordoff, a founding director of the Center on Global Energy Policy at Columbia University. “But the Europeans sent a signal that they intend to sign more long-term contracts for L.N.G. supply, so this should help those projects reach final investment decisions.”

It isn’t only the financial backers that have been reluctant to fund new exploration and production. Shareholders have been demanding a bigger piece of the profits after years of lousy investment returns on energy funds. A typical investor who bought an energy stock fund five years ago would only recently have broken even, according to Morningstar Direct. So the energy industry has been focusing on shareholder returns rather than pouring profits back into its businesses, a strategy the markets refer to as capital discipline.

“Capital discipline isn’t just about which fields you’re going to drill,” said David Lebovitz, a global market strategist at J.P. Morgan Asset Management. “The new approach is going to the profitable fields and drilling five to seven wells, rather than 10. If you’re an energy company, you don’t want to overwhelm the world with oversupply.”

Russia-Ukraine War: Key Developments

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New efforts to isolate Russia. NATO foreign ministers are discussing an expansion of military aid to Ukraine, and the European Union is weighing a ban on Russian coal. The United Nations voted to suspend Russia from the Human Rights Council, while the U.S. Senate agreed to strip the country of its preferential trade status with the United States.

Peace talks. Hope for progress dimmed after Russia’s foreign minister said the Ukrainian side had proposed a new draft deal that deviated from previous versions. Belarus further complicated the situation by demanding to be included in the negotiations.

On the ground. Spurred by reports of Russian atrocities outside Kyiv and alarmed at signs that Russia’s military is about to escalate assaults in eastern Ukraine, many civilians appeared to be fleeing the region.

In the city of Mariupol. More than 5,000 people have died in the southeastern city since the start of Russia’s invasion, according to the city’s mayor, Vadym Boichenko, who said Moscow’s forces have destroyed almost all the city’s infrastructure.

In the portfolios Mr. Maloney manages for clients, he includes the Vanguard Energy exchange-traded fund. This $8.3 billion fund had returns of 39 percent in the first quarter after a management fee of 0.1 percent. Exxon and Chevron are the top two holdings, with a combined weighting of 38 percent. Exxon’s shares grew 36.5 percent in the first three months of the year; shares of Chevron rose 40.1 percent.

Chevron has paused sales of certain chemicals and consumer products in Russia and says it does not have exploration or production operations there. It has a 15 percent stake in an oil pipeline that transports crude oil from Kazakhstan to a Russian terminal on the Black Sea, where shipments have continued uninterrupted. There, Kazakh oil can be blended with Russian crude, though Chevron has said its “efforts are carried out in compliance with U.S. law.”

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

Mr. Maloney said that after the run-up in share prices over the last year, he primarily viewed energy stocks as a hedge against other holdings that might move in the opposite direction, such as airlines, shippers and other companies that are sensitive to fuel prices.

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