Analysts at Morgan Stanley believe the European energy sector's outperformance relative to the broader market has room to continue, as investors are only beginning to price in the risks of a structural shift on the supply side against the backdrop of conflict in the Middle East.

A team of analysts led by Martin Rats upgraded the sector's rating from "in-line" to "attractive." They noted that while rising oil and gas prices can fuel inflation, often lead to higher interest rates, and pressure overall economic growth and equity markets, they are beneficial for energy stocks.

This divergence has been evident since the outbreak of conflict involving Iran: since late February, the Stoxx 600 index has fallen 8.6%, while its energy sub-index has gained 10%. Morgan Stanley analysts cautioned that downside risks remain following this rally, but the macro environment should continue to favor the energy sector over other parts of the market.

"The recent relative outperformance is not yet over," the analysts wrote. "The market is only just beginning to price in a lasting shift in energy security dynamics, effective spare capacity, and the value of stable supply."

Morgan Stanley analysts upgraded BP and Repsol to "overweight," citing their stronger earnings resilience in a sustained high oil and gas price environment, as well as improved capacity to return cash to shareholders as cash flow increases. The bank turned more cautious on more defensive names, downgrading Shell to "equal-weight" due to its relatively limited upside potential in a rising oil price environment.