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The Energy sector has been the worst performing sector in 2012 so far. It has consistently seen weak relative strength compared to other sectors, mainly because of several headwinds attributed to global growth.

Headwinds in 2012

The sector's YTD underperformance is no coincidence. Take a look at the macro economic headwinds that it has faced so far.

  • Global economic growth remains sluggish. Slow growth results in lesser energy demand.
  • After a bullish Q1, EPS estimates in the US have started contracting.
  • Weakness in the prices of crude oil and natural gas.
  • Bad news keep stemming out of China and emerging markets.
  • Europe sovereign debt problems keep rearing their heads out.

Having said that, what's in store for Energy in H2 2012? First, let us take a look at how the first half has treated the Energy sector.

YTD Performance of XLE in 2012

The following table shows how the Energy sector has performed compared to other sectors in the S&P 500. This sector has returned -10.21% in past 1 year, -1.58% YTD and -1.81% in the past 3 months, underperforming hugely compared to other sectors and the S&P 500 in general.

(click to enlarge)

But wait a minute!

In this same table, check the 1 month, 1 week and 1 day performance of the Energy sector.

There has been a technically sound uptrend in this sector recently, with returns of +3.19% in the past month, +1.23% in the past week and +1.16% on 1 day (July 18, 2012).

Looks like a reversal is in the making, and the fortunes of this downtrodden sector are about to rollover for good.

Catalysts

Just like it's underperformance was no coincidence, there must be catalysts causing a possible turnaround in Energy. Let's take a look at these catalysts.

  • Severely undervalued: Energy sector's dismal underperformance in 2012 kind of puts it in the valuation box for questioning. The top 10 holdings of XLE are high quality stocks that have simply been brushed aside so far.
  • Energy prices: On July 10 2012, EIA announced their energy outlook that contained data for 2012 and 2013. WTI Crude average is expected to be $88.50 per barrel, while Brent Crude is at $98.25 per barrel. These numbers bode well Oil industry.
  • China Inflation concerns eased: According to a recent report, China's annual consumer inflation cooled from 3% in May to 2.2% in June. A high inflationary environment in China compels their government to take measures to cool down growth, which could potentially impact demand in energy and commodities.
  • A strong fourth quarter rally: Although this factor is a bit speculative, there are some facts to back that there is a bullish case for the latter half of 2012. The equity allocation in wall street portfolios are at record lows, and the publicly traded companies themselves are hoarding record levels of cash. Two things stem out of this - one is that the low equity allocation cannot last in a low interest rate environment does not last long, and wall street investors will jump in at the slighted hint of a recovery.

    Secondly, high levels of corporation cash usually lead to either stock buybacks, dividend announcements or increased M&A activity (bodes well for asset management firms) - all factors that lead to a bullish rally.

Conclusion and Best Energy Picks

Energy sector has underperformed for the past six months, but recent movement in the sector's stocks and ETFs show that bullish energy is building up.

Investors should carefully select stocks that have good growth stories behind them. My favorites are oil refiners in the gulf coast like Valero (VLO) as they could benefit from pipeline projects in the next two years, and equipment servicing companies like Schlumberger Ltd. (SLB) that have huge potential upside (target price of $87).

Here is a complete list of some high quality plays in the Energy sector apart from XLE (Energy Sector Select SPDR). Some of these also pay decent dividends, that are always welcome.

SymbolNameIndustryDiv. Yield
VLOValero Energy Corp.Oil & Gas Operations2.36%
SLBSchlumbergerOil Well Services & Equipment1.62%
CVXChevron CorporationOil & Gas - Integrated3.35%
COPConocoPhillipsOil & Gas - Integrated4.69%
XOMExxon Mobil CorpOil & Gas - Integrated2.68%
APCAnadarko Petroleum CorporationOil & Gas Operations0.50%
OXYOccidental Petroleum CorporationOil & Gas - Integrated2.50%
PSXPhillips 66Oil & Gas - Integrated2.18%
APAApache CorporationOil & Gas Operations0.79%
NBLNoble Energy, Inc.Oil & Gas Operations1.03%
MPCMarathon Petroleum CorpOil & Gas Operations2.20%
RGPRegency Energy PartnersOil Well Services & Equipment7.59%
CEOCNOOC LtdOil & Gas Operations3.37%
INTWorld Fuel Services CorporationOil & Gas Operations0.38%

Note: I intentionally did not include any Coal companies because there isn't major catalyst for them in the near term, even though some of these companies might be very undervalued. Natural Gas continues to be favorite substitute for coal until global coal demand really shoots up.

Source: Energy's Turnaround Story - Catalysts And Best Stocks