Energy's Loss of Momentum Likely to Persist: Seeing 10% Drop in Coming Weeks

 |  Includes: IEO, IEZ, IXC, IYE, OIH, PXE, PXJ, RYE, XLE, XOP
by: Alan Brochstein, CFA

In early February, I shared my bullishness on big cap integrated oil & gas companies (Big Oil Could Fuel Big Gains in 2011). It turned out to be a great call so far, but only partially for the reasons I suggested. While I remain constructive over the longer-term on companies like Chevron (NYSE:CVX), which I continue to own but at reduced levels in the Conservative Growth/Balanced Model Portfolio, I continue to believe that the rest of the sector may struggle in the near-term.

Energy stocks have come a very long way since the summer, rallying by over 60% (click to enlarge image):

Click to enlarge

Energy stocks have been dominating the market over the past year, with a price return of 37% through Q1 compared to a one-year return of 13.4% for the S&P 500. Over the past 5 years, energy is up 7.8%, well ahead of the 0.5% annualized price return of the S&P 500. In 2011, energy blew away the other parts of the market, returning 16.3%, which was almost double the next-best sector and 3X the return of stocks in general. It was even more explosive for smaller stocks, with S&P 400 mid cap energy stocks returning 18.7% and S&P 600 small cap energy stocks returning an astounding 24.7%.

Well, since the quarter ended, profit-taking has kicked in, with S&P 500 energy stocks declining 2.8%. The damage has been worse for smaller companies, with S&P 400 energy down almost 4% and S&P 600 energy down 3.2%. This comes despite the dollar weakening, oil being somewhat stable and other commodities rising marginally.

I believe that there is more downside ahead in the near-term, as investors continue to rotate into other parts of the market. I described the sudden interest in healthcare, but it's not just healthcare that is benefiting from the rotation, as consumer staples, utilities andcConsumer discretionary are also up so far in April.

Technical View

Perhaps the easiest case in my view is the technical one. I have set a near-term objective for the XLE of 69-70, which would represent about another 10% decline from here. In the chart above, you can see that the run has been quite extended. The 10dma hasn't crossed the 50dma (while the 50dma has been above the 150dma) since late October. I typically get concerned when that type of relationship persists for more than 13 weeks. The chart looks toppy to me, with a couple of gaps from March and April leaving an island. I expect a move to at least the 150dma, perhaps slightly below. Looking at the Fibonacci 38% retracement, it would seem support will be found near 68.50.

Fundamental View

Everything has been going right for the sector, with oil supported by unrest in the Mideast and the aftermath of the Japanese tragedy. On top of these drivers, commodities in general have been lifted by the falling dollar. While I believe that demand is stable to rising, supply is likely to be abundant. The Gulf appears to be ready to be ready for more permitting. New formations are being discovered, and technology is also enabling better extraction. Quite simply, the high price of oil has encouraged more exploration and more investment in recovery.

While supply is something we can debate, a more concerning issue is costs. Specifically, two areas concern me. First, we have seen some tightness in many services and even in certain types of equipment availability. Second, it appears that taxing authorities may be looking to get into the game here, something that could extract a lot from the bottom line. North Sea companies were recently caught off guard by a windfall tax that raised royalties from 20% to 32%. One wonders if this type of confiscation will become popular with other tax-starved countries like ours.

So, my take on the fundamentals is that the rapid rise in oil prices will likely lead to more supply in the long run. We could also see more conservation ahead. Profitability of many companies could be impacted by tightening labor and equipment availability as well as possible taxation. To me, the rubber band has pulled pretty far.

Valuation View

If you look at the overall sector, the valuation certainly isn't an issue. According to Standard & Poor's estimates, the 2011 PE is just 13.1X, a slight discount to the overall market. I find this a bit misleading, though, as the very large components depress the overall average. Quite simply, CVX (8.7X) is cheap, but SLB (22.8X) isn't. Looking at the 41 energy names in the S&P 500, the median forward PE is 17.7. It's quite a diverse range, with many of the big companies below 10 PE but 1/4 of the names above 20. So, the overall PE is not a realistic characterization. It's much worse for smaller companies, with the 24 energy names in the S&P 400 having an average PE of 25.5 and the 21 names in the S&P 600 having an average PE of 23X. These are cyclicals priced like growth stocks!

While I can appreciate the bullish case for energy stocks, I believe that things are way ahead of themselves. Momentum has been the reason many have stayed with the sector, but momentum is rapidly deteriorating. I have shared some technical, fundamental and valuation perspectives that lead me to conclude the overall sector could drop 10% in the coming weeks. I actually believe that this could be positive for the rest of the market, as energy costs are one of the biggest concerns the market faces.

Disclosure: I am long CVX in Conservative Growth/Balanced Model Portfolio