Investors are ignoring the best opportunity in the market right now, says JP Morgan

Essam Al-Sudani | Reuters

Men work for Iraqi Drilling Company at Rumaila oilfield in Basra, Iraq,

Energy stocks offer the best risk-reward in the market, but investors are ignoring the sector after equities and oil prices collapsed in tandem at the end of last year, according to J.P. Morgan.

While U.S. crude oil prices have rallied 36% this year, the S&P 500 Energy sector is up just 16%. That marks a significant decoupling of oil prices from energy equities based on historical trends, the investment bank said in a research note on Friday.

When oil prices were at similar levels in the past, the S&P 500 Energy sector has traded about 7% above current levels and S&P 600 Energy stocks have traded about 30% higher, J.P. Morgan research shows. The divergence is especially true for shares of companies that explore for and produce oil. These ratio of oil prices to these exploration and production stocks is now at a record low.

The sector is also underperforming the market by a wide margin and valuations for energy stocks are at multi-decade lows, the bank says.

J.P. Morgan thinks many investors are simply not paying enough attention to the space. It says “sentiment has completely collapsed,” noting that the energy sector has attracted the most bearish short positions out of any sector.

“Despite improving fundamentals, institutional investor interest remains extremely low based on our recent meetings and big data indicators,” analysts led by J.P. Morgan’s Dubravko Lakos-Buja said. “With the sector’s benchmark weight declining to only 5%” — the lowest in about 15 years — “investment firms are reducing sector exposure and cutting back on in-house research coverage.”

With oil prices forecast to average $65 a a barrel this year, J.P. Morgan says many drillers can break even on new wells, allowing them to invest in growth. The bank is now expecting positive guidance and revisions when exploration and production companies report first quarter earnings.

“After a three-year hiatus, Energy companies are ramping buybacks and we expect strong activity in 2019 based on announcements and record existing buyback programs,” Lakos-Buja said.