Energy stocks are up, yet energy prices are falling. Where do we go from here?

Holding energy stocks? You’ll want to read this one. Energy prices and stocks have diverged in recent months.

• Oil prices have returned to their start-of-the-year levels after a massive run.
• The Energy Select Sector SPDR Fund (NYSE:XLE) — a basket of oil and gas-related stocks — are still up 60% this year.

Per Bespoke Investment Group, this is the first time there’s been this large of a difference since 2006 (WSJ).

The two are usually highly correlated. The higher oil prices go, the more profits energy companies make, and vice versa.

Where do energy stocks go from here?

The bull case…

Energy companies have learned from their past mistakes: not investing in new production when times are good.

Instead, they’re focusing on generating profits and returning capital to shareholders (dividends/buybacks).

The best-case scenario: Energy prices rise → energy companies continue to see record profits → they continue to return profits to shareholders → all is good

In this case, energy stocks and their record profits depend on rising oil prices.

The bear case…

Energy stocks may eventually follow oil prices down.

The worst-case scenario: Recession → economic activity falls → energy prices drop further → energy companies lower earnings estimates → stocks go down

Per Goldman’s research unit, hedge funds are increasingly betting against energy stocks — with shorts outpacing long buys six to one (BBG).

Investors: Weigh the opportunity cost

Sitting on major oil gains? Might be a good time to consider taking some money off the table. Think about the opportunity cost:

• Ride energy stocks and take a chance that oil prices move back up, or…
• Rotate into beaten-down stocks in sectors where valuations look more attractive relative to the past.