Current energy sector valuations lag broad market valuations.
Cyclical factors are turning in favor of volatile energy stocks.
Now could be a good time to rotate into the energy sector using ETFs.
Energy is an undervalued target for strategic asset allocation. Like commodities in general, the energy sector is highly volatile. Energy swings higher than the market when times are good and falls harder when times are bad. Still reeling from global economic woes, the energy sector is down relative to the S&P 500.
Energy is a good value
The following graph shows the price of U.S. crude oil over the past 10 years:
Source: Federal Reserve Bank of St. Louis Economic Data
The S&P 500 has recovered all of its losses -- and then some -- since the onset of the financial crisis. In addition, the U.S. economy has recovered all of the jobs lost since the Great Recession.
In contrast, crude oil prices are still far below their prior peak of about $140 per barrel prior to the financial crisis. As of this writing, crude oil was trading around $94 per barrel. Oil has been pretty much flat for the past three years, even as the stock market has soared, as shown in the following graph:
This state of events is not likely to last much longer. The U.S. economy continues to improve.
A rising economy
The Conference Board's most recent survey of consumer sentiment shows the highest level of confidence in the economy since October 2007. Consumer spending makes up about 70% of the entire U.S. economy. Unemployment has fallen from a peak of 10% during the height of the Great Recession to 6.2% today.
Inflation is stable, at least for now. The Federal Reserve has indicated that it has no plans to push near-zero rates higher any time soon. Based on these factors, today's stock market levels appear to be justified by economic fundamentals. If the economy continues to improve, demand for petroleum and related products is likely to accelerate over the next three to five years.
Bubble: what bubble?
Some say that the stock market is already in bubble territory, including Nobel-Prize winning economist Robert Shiller. However, today's stock market price-to-earnings ratio is nowhere near previous bubbles.
Today's market is valued at 17 times earnings, far below the dot-com bubble, when the market carried a PE ratio of 44 times earnings. In addition, today's market PE ratio of 17 is not far from the long-term historical average of about 15 times earnings.
The Vanguard Energy (NYSEARCA:VDE) ETF holds $3.9 billion in assets. This ETF contains 162 U.S. stocks with a median market cap of $59.8 billion. The Vanguard Energy ETF does not offer exposure to international supermajors, such as Royal Dutch Shell PLC (NYSE:RDS.A) (NYSE:RDS.B) or Total SA (NYSE:TOT).
The fund's largest holdings are Exxon Mobil (NYSE:XOM) and Chevron (NYSE:CVX). U.S. supermajors are valuable companies. The technical expertise of these big corporations remains in demand as oil becomes more challenging to locate and develop.
The Vanguard Energy ETF is a market-cap weighted fund. The largest categories by weight are:
- Integrated oil and gas at 37.10%.
- Exploration and production at 28.50%.
- Equipment and services at 17.90%.
Consistent with Vanguard's emphasis on low costs, the Vanguard Energy ETF carries an expense ratio of 0.14% -- one of the least expensive energy ETFs available.
Currently, the Vanguard Energy ETF is trading at 15 times earnings. The Vanguard ETF has a yield of 1.58%.
The Energy Select Sector SPDR (NYSEARCA:XLE) ETF is another market-cap weighted option available to investors. This ETF contains 46 U.S. stocks compared to Vanguard's 162. Like the Vanguard ETF, there is no exposure to international supermajors.
The Energy Select Sector SPDR ETF has an expense ratio of 0.16% -- slightly higher than Vanguard's 0.14%. The Energy Select Sector SPDR ETF's oil-and-gas category weightings (e.g., exploration and production vs. equipment and services) are about the same as the Vanguard ETF.
Perhaps the biggest advantage of the Energy Select Sector SPDR ETF is that it is the largest and most liquid energy ETF available. The SPDR ETF has $11.4 billion in assets compared to Vanguard's $3.9 billion. Trading volume is higher for the SPDR ETF. Thus, the SPDR ETF could offer superior bid-ask spreads.
The Energy Select Sector SPDR ETF is currently trading at 15 times earnings. The SPDR ETF has a yield of 1.75%.
For investors seeking exposure to not only U.S. companies but also international oil-and-gas companies, the iShares Global Energy (NYSEARCA:IXC) ETF is a good choice. Royal Dutch Shell PLC, Total SA, and British Petroleum PLC (NYSE:BP) are three of the top five holdings in this market-cap weighted ETF. The other two are Exxon Mobil and Chevron. In total, the iShares Global Energy ETF contains 93 companies around the world.
The iShares Global Energy ETF is more concentrated towards integrated oil-and-gas companies, which comprise about 50% of total assets. Exploration and production companies make up about 25% of assets, and equipment and services companies make up about 9%. The iShares Global Energy ETF carries an expense ratio of 0.48%, which makes it a bit pricier than both the Vanguard and SPDR ETF. International investing tends to incur higher costs.
The iShares Global Energy ETF is trading at a PE ratio of 13 times earnings. The iShares ETF has a yield of 2.45%.
The energy sector is highly volatile. Energy is sensitive to consumer and producer demand as well as the overall state of the economy. Gas prices can swing wildly from one extreme to the other.
Geopolitical risk is a major factor to consider in the energy sector due to the location of vast petroleum reserves in far-flung countries that may not be friendly to the United States. The U.S. domestic energy boom is beginning to change things, thanks to hydraulic fracturing methods. However, the Organization for Petroleum Exporting Countries continues to exert influence on the market for oil and gas.
While nothing to write home about, energy stocks do provide some diversification in relationship to the broad market, as measured by the SPDR S&P 500 (NYSEARCA:SPY) ETF. The following chart shows the correlation coefficients for each of the energy ETFs discussed above compared to the SPDR S&P 500 ETF over the past 10 years:
Source: Author's analysis of data from YCharts.
The iShares Global Energy ETF has the lowest correlation of 0.71 compared to the S&P 500 index. Anything less than 0.75 is generally considered to be a low level of correlation that provides meaningful diversification benefits.
The other two ETFs have correlations of about 0.80. This is better than 1.00 (i.e., perfectly positively correlated and moving together in lockstep) but far from uncorrelated (i.e., 0.00 or negatively correlated). In short, investors interested in an energy ETF for diversification purposes may want to consider the iShares Global Energy ETF, since it does not move in lockstep with the market to the same degree as the other ETFs.
By investing in an energy ETF, rather than individual oil-and-gas companies, investors can shield themselves from idiosyncratic risk embedded in individual energy stocks. Broad-based energy ETFs also provide geographic diversification: within the U.S., across international borders, or both.
The bottom line
The U.S. economy is improving and the stock market is soaring to new heights, while the price of oil remains tame. This situation is not likely to continue. Oil could become more expensive as demand picks up due to an expanding economy and an improving labor market. Now could be a good time to invest in the energy sector before prices rise.
Disclosure: The author is long VDE. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.