3 reasons why oil stocks could drop further

Investing.com -- While oil equities have rallied strongly this year, they have declined in the last couple of sessions, with analysts at Bernstein saying the same forces that drove the gains could also trigger further declines.

Analyst Bob Brackett outlined three key factors that typically cause oil-linked stocks to retreat.

“Oil-linked equities have risen year to date for three reasons: overall beta to oil price, sector rotation, and geopolitical risk premia,” Brackett wrote.

“Oil-linked equities similarly fall when: (1) the cost of oil is too high, inducing demand destruction, (2) sector rotations end, and (3) geopolitical risk premia fall.”

The first risk, demand destruction, appears limited for now. According to Bernstein, oil prices remain well below levels that have historically triggered significant economic strain.

Brackett noted that oil cycles tend to peak when energy costs absorb around 6% of global GDP, but “we are well below such levels today.”

“If the cost of oil exceeds 5% (again we are closer to 4%), then the price of oil one year forward is nearly always negative (and of course oil equities follow),” the analyst explained.

The second factor is sector rotation. Bernstein said recent gains in energy stocks partly reflect investors shifting capital away from technology.

“Worries about the role of AI have driven flow from software into an oil sector which felt less assailable and had a reasonable entry point at lower oil prices,” Brackett wrote. “Given the overall lack of upside across names in our sector, we’d argue it’s a potential risk for the rotation to reverse.”

Finally, oil equities could weaken if geopolitical tensions ease. Bernstein said the current risk premium tied to global conflict “could persist for weeks, months or longer,” but a durable resolution would likely remove a key support for the sector.

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