The energy sector appears to have fallen out of favor among general investors, with its weighting falling from about 16% at the start of 2008 to 4.1% as of April 30, 2024.
Despite growing demand for power and energy amid efforts to decarbonize and generate strong cash flows, investors often wonder what the appropriate weighting of the sector in the index should be.
In an attempt to answer this question, strategists at Mizuho Securities note that the energy sector looks “cheap” compared to the broader market based on metrics such as EV/EBITDA and FCF/EV, despite improving fundamentals.
While XLE has outperformed the index by about 6% year-to-date, investors are increasingly curious about how much further the sector’s ranking may change relative to the broader market, Mizuho said.
In its analysis, the investment banking firm compared the energy sector’s market capitalization weight in the S&P 500 index and its contribution to two-year forward free cash flow from 2008 to 2024, revealing a notable discrepancy.
While energy has historically contributed about 9.4% to market free cash flow, its market weight once matched that contribution. However, after 2018, this ratio was disrupted, despite the growth in shale oil production 3.0.
By April 30, the sector is expected to contribute about 12% of the S&P 500’s free cash flow in 2025, strategists say.
“While a tripling of the sector’s market weight from current levels seems unlikely, we believe the sector should account for 8-9% of the overall market,” the strategists calculated.
“This suggests that despite recent strong growth, the sector has more room to grow,” they added.
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In terms of specific stocks, Mizuho still favors quality players such as Chevron (NYSE:), Coterra Energy (NYSE:), Civitas Resources (CIVI), Diamondback Energy (NASDAQ:), EOG Resources (NYSE:), Permian Resources (PR), Range Resources (NYSE:) and Chesapeake Energy (CHK) ) “to participate in this potential uptrend.”