Energy stocks had a blowout performance this year. In 2023, the outlook is more uncertain

After enjoying a monster rally in 2022, energy stocks are heading into an uncertain new year. Energy stocks surged this year after the war in Ukraine interrupted the global oil supply, and drove up the price of a barrel of oil. Soon after the start of the conflict, Brent crude topped $120 a barrel in March before eventually falling back to about $83 a barrel this month. For investors, a bullish stance on energy coming into the year has meant outsized gains. Energy is the only sector in the S & P 500 that is higher in 2022, while the Energy Select Sector SPDR ETF is up 56% this year. Still, even investors positive on the sector are pulling back on their allocations heading into 2023, as they expect the outlook will be more challenging. "We're still overweight energy, but less so than we were," said Kevin Holt, chief investment officer for Invesco U.S. Value Equities and a portfolio manager at the Invesco Comstock Select Fund (CGRWX). The fund's roughly 13% allocation to the sector , far more than the nearly 9% weighting that peers in its category have, helped the fund stay in the green this year. "Energy underperformed for the better part of a decade. So even though it's outperformed the last two years, it still underperformed overall over the last 10 years," Holt said. In the near term, investors worry that further aggressive action against inflation from the Federal Reserve could tip the economy into a recession and weigh on oil demand — though a possible reopening in China could at least temporarily lift those concerns. On the other hand, severe undersupply given years of underinvestment in the sector, as well as growing geopolitical risks in Russia and elsewhere, could continue to drive up the price of oil over the longer term. Here is where investors are looking for outperformance in the new year. The supply picture For Billy Bailey, founder and portfolio manager at Saltstone Capital Management, the outlook for energy looks the most constructive than it has in many years. His hedge fund has less than $50 million in assets under management. "This industry has been decimated both on the buy side and the sell side. Investors are not coming back. More people are still exiting the sector than they're entering," Bailey said. "And all of that creates a scenario where you're going to continue to be massively under invested in a depleting asset, which means that supply is going to be less than demand, which means the prices are going to have to go higher." The hedge fund manager said he has more exposure to the actual commodity, as well as to oilfield service companies, than he does to exploration and production companies. One of his favorite picks heading into 2023 is oilfield services company ProPetro , a firm whose management team he's been familiar with since before ProPetro's public debut in 2017. He thinks the stock is trading at an "attractive valuation," even as shares are up more than 26% year to date. Meanwhile, Joseph Sykora, equity analyst at Aptus, is particularly bullish on oil and gas royalty companies. These firms have an advantage over E & P operators such as an Exxon Mobil or Pioneer Natural Resources, as they own the underlying royalty streams and mineral rights. This means they can ride any upswing in commodities prices while limiting downside from mounting inflationary pressures. "If you're receiving $70 for a barrel of oil, and the cost of that barrel to produce it has gone up, that's just a negative impact on your margins," Sykora said. "If you're a royalty company, you're receiving a percentage of the revenue that's generated from that well, regardless of what it costs for the company to extract it." One royalty company the analyst said he prefers over others is Viper Energy Partners . Not only does the company have a "pretty prolific" position in the Permian Basin, it is also majority-owned by Diamondback Energy . For investors, this means that Viper has "complete visibility" into when its acreage will get drilled, compared to peers such as Kimbell Royalty Partners or Texas Pacific Land , Sykora said. "You might have fantastic acreage, you may have good valuations, whatever it might be, but if you don't know when that acreage is going to be drilled and developed, then it's hard to value what it's worth," he said. These stocks have outperformed in 2022. Shares of Viper Energy are up 51% this year, while Kimbell Royalty Partners and Texas Pacific Land are up 22% and 100%, respectively. Ongoing geopolitical risks To be sure, not everyone believes that the outlook is positive for energy stocks, especially without the resolution of some ongoing geopolitical disruptions. In fact, some experts believe they could significantly worsen from here. According to Matt Gertken, chief strategist for geopolitical strategy and U.S. political strategy at BCA Research, the price of oil could be pushed into punitive territory — possibly toward $150 per barrel — should relations with Russia or the Middle East worsen in the coming year. That would be bad even for energy stocks. For example, the European Union's oil embargo on Russia over the ongoing war in Ukraine, which Moscow has threatened retaliation for, could result in "could result in bigger declines of Russian oil production than the world expects next year," possibly over the next six months, Gertken said. Meanwhile, the Middle East could be reemerging as a greater geopolitical risk in 2023, Gertken said. As tensions grow between the U.S. and Iran, that could make any strategic agreement between the two countries more difficult to reach. For investors, Gertken urged they seek safety in government bonds to defend their portfolios against a downturn, as well as any defensive sectors in equities over cyclical sectors. If they do add to their energy allocation, he stressed a preference for U.S. energy over global energy for a "more stable" investment environment. "In an environment that is fundamentally supply constrained like today, petro state producers of oil have enormous geopolitical leverage. And Russia can use that leverage, just as Iran can use that leverage in, say, production in the region," he said. "And so that's the key point. Because what it's says to a very short-term and tactical investor is, 'well there's more upside,' but what it says to a medium- or longer-term investor is that we have a dynamic that can be punitive for growth," Gertken continued.