The energy sector has underperformed the overall economy and the stock market for almost three years. However, a reversal is underway.

The rise in crude oil prices puts a foundation under this change of outlook, but the broad economic recovery is most responsible.

The oil and gas extraction industry and its supporting services reached a cyclical low in the third quarter of 2009, according to Statistics Canada figures. Operating revenue dropped by 43%, on a quarterly basis, to $33.6 billion from $59.3 billion in Q3 2008. Since then, it has recovered by 18% to $39.7 billion in Q3 2010.

This swing is more volatile than the broad economy, which is typical for a resources industry. StatsCan figures reveal that operating revenue for all non-financial industries dropped by 12% from late 2008 to the first quarter of 2009, and has risen by 9% since.

More striking is the sharp rise in cash generated by the energy sector and the sharp improvement in its profit margins. For example, cash flow from operations had climbed by 191% by Q3 2010 from a low in Q1 2009. That was preceded by an 82% drop. (See chart, top right.)

The broad economy lost less but has also gained less; cash flow dropped by 12% to its Q1 2009 low but has rallied by only 9% since. It has been an uneven rally because cash flow through the nine months ended Sept. 30, 2010, had dropped below the levels in the corresponding period of 2009.

Energy-sector profit margins have gained more strongly since their Q1 2009 low. Net profit margin was a negative 1% then; in Q3 2010, it reached 9.4% in a zigzag rise. For all non-financial industries, the net profit margin has been around 5% over the past five years, but rose to 6.4% in Q3 2010.

Return on equity shows the broad trend and how much ground the energy sector must regain to match its returns of four and five years ago. Twelve-month ROE for the sector has dropped to a recent low of 2.7% from almost 20%. ROE rallied by only 5.7% in the year ended Sept. 30, 2010.

The energy sector shines in balance-sheet strength. Its shareholders’ equity climbed to a recent high of 49.4% of total assets from 40.7% in 2006. The all-industries ratio for Q3 2010 was 41.1%.

Meanwhile, energy share prices have been perking up. The S&P/TSX GICS energy sector index has underperformed the overall market since mid-2008. In the last two months of 2010, the energy sector gained in relative strength (see chart, bottom right) as a result of a 20% rise in prices in the second half of 2010.

Technical indicators are bullish, such as moving average convergence/divergence, 12-month rate of change and intermediate-term moving averages. Dividend yield on the energy sector index has held at almost 3%, dropping to 2.7% in December as the price index gained while the dividend payout barely changed.

Within the energy sector, though, there are big variations in performance. Exploration and production — the largest subsector in terms of earnings, dividends and value of trading — had led the recovery. Now, the smallest segments of the energy industry are showing the strongest price improvement. Oil and gas drilling and equipment and services have rallied strongly since August, gaining 35% and 32%, respectively.

They have much catching up to do. The S&P/TSX drilling subindex has dropped since early 2006 as earnings adjusted to the index declined to $17 from $500; its dividend has been stuck in the $12 range for the past two years.

Earnings for the equipment and services subindex have been particularly volatile, and its dividend has dropped to a new low. The stock market is signalling better times ahead for this subindex. IE