The sector’s surge is best explained by the recent rally in oil prices, which happens to be tied to the most serious risk in global markets: the growing conflict in the Middle East.

Oil has taken off due to fears of supply-side disruptions caused by rising tensions in the region, starting with Hamas’ October 7 terror attack on Israel and the nation’s subsequent retaliation. This past weekend, Iran fired over 300 missiles at Israel after an Israeli attack on Iranian military officials at a diplomatic facility in Syria. Israel was mostly able to neutralize that threat.

Brent crude oil prices are up 18% year-to-date to $90 per barrel, and some pundits expect it to hit $100 in the coming months. In turn, investors have shifted money toward oil companies.

However, supply concerns can’t fully explain oil’s latest surge. Fuel demand is robust since the economy has been better than anticipated, Goldman Sachs strategists recently remarked. Strong consumer spending has underpinned oil prices, which has then driven lofty inflation.

In a mid-April note, David Kostin, the chief US equity strategist at Goldman Sachs, wrote that oil prices likely won’t rise much further from here, barring a significant economic deterioration or the conflict in the Middle East. He added that Brent prices should stay under $100 per barrel.

Energy stocks have hedging power, are fueled by strong catalysts

Higher oil prices are a headache for most companies, Kostin noted, as rising fuel costs prop up inflation and put pressure on profit margins and consumer spending. Still, he added that the impact on S&P 500 earnings is mostly neutral, a relief in a crucial Q1 earnings season.

Energy stocks are a smart bet now since they can help investors hedge against risks that higher oil prices and heightened geopolitical conflict pose to the rest of their portfolios, Kostin wrote.

“Commodity-exposed sectors currently serve a useful role in investor portfolios, particularly as hedges against geopolitical and inflation risk,” Kostin wrote. “Commodities typically perform well during historical episodes of high geopolitical risk and periods of rising inflation.”

Mutual fund managers have gotten that memo, as Kostin noted that those active managers are overweight energy as well as the similarly commodity-heavy materials sector. However, hedge fund managers are underweight both sectors by the largest level in about 10 years.

Besides offering near-term downside protection, energy stocks seem to be an especially sound long-term investment since they’re historically cheap, Kostin wrote.

In fact, the energy sector’s 12.3x forward price-to-earnings (P/E) ratio is over 34% less than the S&P 500’s 18.8x mark, which the strategy chief noted is the largest relative valuation right now — and one of the biggest discounts in the last three decades. At the same time, Goldman Sachs found that energy has the most substantial free cash flow yield among sectors at 7%.

“While not a strong predictor of near-term returns, the valuation discount creates an attractive entry point for longer-term investors and should support capital return programs,” Kostin wrote.

Another compelling selling point for energy stocks is that there will be strong long-term demand for oil, Kostin wrote. Emerging markets will need more fuel as they develop, and rapidly evolving technologies like artificial intelligence are highly energy-intensive.

“The long-term prospects for the energy sector remain attractive due to the combination of a large valuation discount and structural tailwinds,” Kostin wrote. “Our commodities strategists expect long-term energy demand will remain solid, in part because of increased global energy demand from the structural rise in transportation needs in EMs and AI.”

3 top energy stocks set to perform well

Even if oil prices don’t soar, Goldman Sachs analysts think energy stocks can stay hot — especially three oil & gas companies that Kostin highlighted in his note: refining giant Marathon Petroleum (MPC), oilfield services outfit Schlumberger (SLB), and exploration & production firm ConocoPhillips (COP).

All three stocks will enjoy resilient long-term energy demand, Kostin wrote. They’re also cheaper than the market, with earnings multiples ranging from about 8.8x to 17.7x.

Of the three, Marathon has easily run the furthest. Its 39.5% year-to-date gain is far above ConocoPhillips’ 12.2% return — not to mention the 0.7% loss from Schlumberger. Each firm has pulled back lately alongside the slight dip in oil prices and would benefit if the rally resumes.