It’s been a good year so far for energy investors on the heels of a strong finish to 2013, and there appear to be both room and appetite for further buying.

Rallies require a pause to digest gains, and if this summer’s pullback was a test, it’s fair to say energy stocks passed with flying colors.

This is how a leading bull market sector should behave. The selling pressure has been modest to non-existent, suggesting lower prices have been mostly caused by a shortage of committed buyers during the summer trading doldrums rather than weak hands bailing out. The long-term and short-term price trends as exemplified by the 200- and the 50-day moving averages remain bullish, and the sector has hung on to much of its relative 2014 outperformance against the broader market averages.

The Energy Sector Select SPDR ETF (NYSE: XLE) is up 11% this year (as of Aug. 29), vs. 8% for the S&P 500. The SPDR S&P Oil & Gas Exploration & Production ETF (NYSE: XOP), which more or less equal-weights 87 stocks and so gives more preference to the small and midcap names, is up 14% in 2014.

Moreover, the XOP is finishing the month strong, with a gain of more than 2% this week. The XLE is up more than 1% over the same span, while the S&P, record and all, has risen less than 0.5%.

This despite the fact that oil prices have given up all of their gains this year, October futures for West Texas Intermediate trading at a seven-month low just two days ago.

Natural gas prices swooned in June and the first half of July on the cool summer weather but have stabilized since and recently edged higher.


Source: Nasdaq.com from NYMEX data

Despite these headwinds, S&P 500 energy stocks posted a 12.4% year-over-year earnings gain in the second quarter vs. 8.1% for the index as a whole, according to Zacks Research. The fact that they did so on revenue growth of just 2% suggests an encouraging trend in profit margins, though the year-over-year comparisons in the sector tend to be noisy given the typical volatility of energy prices.

Could those prices head lower? The answer, always, is absolutely. Will they? I wouldn’t take that bet.

Between the damper ISIS has put on the expected crude production growth in Iraq, renewed civil war in Libya and the strong likelihood that Russia’s future output will be hit by fresh sanctions more effective than the hand slaps issued so far, North American shale and oil sands remain the principal source of global supply growth. And while drilling efficiencies are bringing costs down, investment would slow in a hurry were crude to drop another $10 to $85 a barrel.

Saudi Arabia, the only OPEC producer with meaningful capacity slack, would likely curb production quickly were that to happen.

In the meantime, fuel demand in the US, which still accounts for 20% of global consumption, was up 2.1% year-over-year over a recent four-week stretch, and crude throughput at refineries was up 3.9% year-over-year over the same period, boosted by growing fuel exports.


Source: Howard Weil from EIA data

But the relatively robust energy markets fundamentals and the market-beating capital gains of the last eight months aren’t the whole story. An important context here is how badly S&P 500 energy stocks have lagged behind the S&P 500 since this bull market began in March 2009.

Source: Yardeni Research

As the chart suggests, this year’s relatively strong performance remains for now a minor correction in a long-term trend of serious underperformance.

Fortunately, the S&P 500 energy sector isn’t the entire energy story either. It doesn’t include most of the midstream master limited partnerships that have proven to be some of the best investments in the world over the last 15 years. It obscures the recent gains by refiners. And it certainly doesn’t fully convey the growth at the companies driving the shale drilling revolution in the core of the most prolific plays.

Five years ago, Continental Resources (NYSE: CLR) had a market capitalization of $6 billion. Now it’s at $29 billion, more valuable than nearly 70% of the companies in the S&P 500, an index in which it’s still not included.

Continental shares hit a record intraday high on Aug. 27, and have returned 87% since we recommended them 18 months ago. Earlier in the month, the company reported a 29% revenue surge and a 24% production increase, year-over-year. Continental’s continuing mastery of the Bakken and other shale formations exemplifies the attractions of the best shale drillers as companies with fast-growing revenue, continuous technological advances, improving returns and the willingness to invest in the future.

Most of the other portfolio recommendations, old and relatively new, aren’t performing too shabbily for us either. First Solar (NASDAQ: FSLR) is up 90% in a year, Carrizo Oil & Gas (NASDAQ: CRZO) 50% since December; Pacific Ethanol (NASDAQ: PEIX) 45% since July 10, Energy Transfer Equity (NYSE: ETE) 34% since March, SemGroup (NYSE: SEMG) 32% since May. They haven’t all been quick winners, of course, but right now a lot more have than haven’t.

Certainly, things could have gone a lot worse. And one day they undoubtedly will. But before then they might, quite possibly, get even better.