Looking for returns in current market conditions? ​The market has delivered some underwhelming returns so far this year, but for one corner of the market, 2022 has been outstanding…

Anyone that’s opened a power bill lately shouldn’t be surprised that energy stocks have soared — the ASX 200 Energy Sector Index (XEJ) is up more than 40% since January 1 against a fall of around 6% in the S&P/ASX 200.

The energy index contains the 11 energy companies in the S&P/ASX 200 that primarily operate in the oil, gas and coal industries, including Whitehaven Coal (+227% YTD), New Hope Corp (+180% YTD), Stanmore (+150% YTD), Yancoal (+87% YTD) and Woodside (+72% YTD).

Here’s the performance of the energy index as compared to the ASX 200 so far this year:

Simply put, the reason for the sector’s outperformance is a result of the high prices of coal, gas and oil seen this year. These higher prices work to the benefit of energy companies by increasing profit margins, at least up to a point where prices get too high and create demand destruction.

​During the pandemic, many energy companies experienced severe losses when commodity prices were low, so they exercised extreme capital discipline, hoping to ride out the pain and position themselves for a post-pandemic comeback.

​Now that commodity prices have more than recovered and production has resumed, energy companies are in a stronger position but, of course, not without risks.

There are many reasons for this, and oil, gas and coal are each impacted by a whole host of varying factors, not the least being a cut in energy supply from Russia.When the economy slowed down during the pandemic and many industries had to shut down operations, there was a decline in energy demand, so supply was cut in response. But once the economy began to recover, energy supply struggled to catch up to the quickly recovering demand, and as inflation soared, energy prices started to rise fast.

These rising energy prices were significantly worsened by the Russia-Ukraine war when Europe rejected oil and gas from Russia, but no immediate alternative was available to replace Russia’s exports.

Before the war, Russia was the world’s largest natural gas exporter, the second-largest oil exporter, and the third largest coal exporter. But its invasion of Ukraine led many countries to apply sanctions on Russia, including banning the import of its fossil fuels. We can add to these other supply disruptions, including OPEC cutting oil production to shore up prices.
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All this means energy supplies have been stretched globally, relying on other energy exporters, including Australia. Already a significant energy producer and exporter, Australia isn’t facing supply constraints but is seeing surging demand.

There are questions about whether energy prices will continue to retreat and fall back to pre-war levels or remain around their current high levels for the foreseeable future.Some are even forecasting a longer term step change to higher energy prices as energy consumers, especially industrial businesses, rely on the surety of supply. This makes a return to normal where the Russian energy supply is added back into the mix after the war ends unlikely since Russia has caused irreparable damage to its reputation, particularly to its European energy customers.

Of course there are a number of possible headwinds, including a slowing global economy and sustained soft demand from China.

There’s also the global transition to renewables; however, widespread adoption of solar, wind and hydroelectricity are still a way off and continue to face technological challenges such as large-scale battery storage challenges.

Most forecasts point to, at least in the medium, fossil fuel prices not being significantly impacted by the transitions to renewables. Government stimulus heavily supported renewables to date, but not much of the funding required isn’t quite available, with rising inflation and higher interest rates being more immediate concerns.

ASX energy investors meanwhile continue to enjoy the good times.