Energy has been the best-performing sector in the S&P 500 so far this year, climbing about 20% year to date. Yet, according to Morgan Stanley analysts led by Devin McDermott, much of the recent move reflects a re-rating that leaves valuations closer to their long-run norms, meaning that further upside is increasingly dependent on positive earnings revisions rather than additional multiple expansion.
The bank's note highlights that while higher crude prices have played a role in the rally, there has also been notable multiple expansion across much of the energy complex alongside a broader cyclical rotation. As a result, the sector's valuation picture has changed materially over the last several months.
Valuation dynamics
Morgan Stanley reports energy is trading at roughly a 43% discount to the wider market. That compares with an approximate 53% discount at the start of the year and with a pre-Covid median discount of about 35% during the 2010-2019 period. Within the sector, Integrated oil companies and Services firms have been the most significant drivers of the rerating.
The analysts note Integrated majors now trade back in line with their long-run relative multiples versus the market, while Services have moved to near five-year average levels. At the same time, forward EV/EBITDA multiples for Integrated Oil & Gas sit at the 95th percentile of their post-2010 history, according to the bank's data.
Fundamentals and oil market outlook
Morgan Stanley characterizes the near-term fundamental backdrop as somewhat soft. The bank expects the oil supply-demand balance to improve beginning in 2027, but cautions that the surplus is likely to worsen before it improves. Analysts point out that oil prices have been in a clear downtrend over the last year and that much of the recent price strength has been driven by geopolitical uncertainty rather than improving underlying fundamentals. Given those conditions, they say risks are skewed to the downside in the coming months.
Inventory developments are a central concern: global oil and product stocks have built by more than 400 million barrels over the past 12 months. Additionally, Morgan Stanley expects OECD inventories to rise in 2026, a pattern the bank believes should exert pressure on Brent and WTI prices.
Earnings revisions and market positioning
The breadth of earnings revisions inside energy has been uneven, the note observes. Most major sub-sectors have seen negative relative revisions, with Exploration & Production (E&P) companies and Integrateds among the weakest in terms of downward revisions. Services firms, by contrast, show some pockets of positive estimate revisions.
Hedge fund exposure has also been concentrated: positioning is elevated in Services and Integrateds, while allocations to E&Ps and Midstream remain relatively subdued.
Investment guidance
Against this backdrop of tighter valuations, softer near-term fundamentals, uneven earnings momentum, and concentrated positioning, Morgan Stanley advises a cautious stance. The bank recommends sticking with a defensive playbook for now and waiting for a pullback before broadening exposure to the sector.
This view places emphasis on the need for positive estimate revisions to underpin further gains, rather than counting on continued multiple expansion to drive returns.