Energy - Still A Key Sector To Own

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Includes: APA, CVX, EOG, OXY, PSX, XLE, XOM
by: Timothy McIntosh

Summary

The energy sector offers excellent long-term returns with low correlations to other major sectors.

The sector offers several attractive dividend-paying stocks.

It is very oversold, offering investors a unique opportunity to add exposure.

The sector weight within the S&P 500 is at an all-time low.

The companies within the sector that have exposure to the Permian region are most attractive.

My last major article on the energy sector was written four years ago. I argued that the energy sector should be a key component to an investor's portfolio. At the time, the energy sector accounted for an 11% weighting of the benchmark S&P 500 Index. Since that time, the energy sector has dramatically underperformed the market and the weight of the sector has fallen precipitously:

12/31/16 6/30/16 12/31/15 12/31/14 12/31/13 12/31/12 12/31/11
Energy 7.56% 7.40% 6.50% 8.44% 10.43% 11.05% 12.35%

Source: Standard & Poor's

Today, the sector accounts for a measly 7.56% of the overall market index. This is primarily due to the collapse of oil. In examining the price of West Texas Intermediate (NYMEX) crude oil, the performance is extremely poor. This had a dramatic impact on oil company profits. It was especially critical considering the high dividend payments along with elevated capital spending. These two line items ate up free cash flow, causing many energy companies to either reduce dividends and capex or go to the debt market to raise cash.

Source: MacroTrends

If you examine the chart of the Energy Select Sector SPDR ETF (NYSEARCA:XLE), there is a high correlation between the performance of the price of WTI vs. the XLE. This has led to strong underperformance for the sector, and ultimately the weighting vs. the market has declined by a substantial margin.

Source: BigCharts.com

There are three merits of owning stocks in any particular sector:

  1. The sector provides attractive dividend stock candidates.
  2. The sector provides diversification.
  3. The sector provides outsized investment returns over long-term horizons.

The energy sector has a plethora of strong dividend stocks even despite the collapse of oil during the past two years. Although many firms scrapped or reduced their dividends, most of the firms within the sector including Chevron (NYSE:CVX), Occidental (NYSE:OXY), and Schlumberger (NYSE:SLB) have either maintained or increased their annual dividend. Below are the major energy companies with market cap and dividend yield. There are 15 primary companies within the sector that pay solid dividends and have growth potential:

NAME Price Cap Yield Symbol
Apache 49.36 18.73B 1.92 APA
BP p.l.c. 33.29 109.95B 6.98 BP
Chevron 109.59 207.46B 3.83 CVX
ConocoPhillips 46.06 56.92B 2.22 COP
Eni SpA 30.98 55.39B 5.58 E
Exxon Mobil 80.92 335.436B 3.64 XOM
Halliburton 50.35 43.63B 1.34 HAL
Hess 47.36 14.97B 1.96 HES
Marathon Petroleum 49.97 26.4B 2.81 MPC
Occidental Petroleum 61.56 47.04B 4.69 OXY
Phillips 66 77.21 40.0503B 3.22 PSX
Royal Dutch Shell plc 53.76 230.16B 6.76 RDS-B
Schlumberger Limited 77.69 108.28B 2.38 SLB
TOTAL S.A. 49.27 117.7817B 5.09 TOT
Valero Energy 66.58 30.02B 4.24 VLO

Source: Yahoo Finance

Additionally, the sector provides excellent diversification through low cross correlations. For example, in the past 10 years, the energy sector has maintained the second lowest correlation among all major sectors:

SPY XLU XLE XLP XLV XLF XLK XLY XLI
SPY SPDR S&P 500 1 - - - - - - -
XLU SPDR Select Sector Fund - Utilities 0.504 1 - - - - - -
XLE SPDR Select Sector Fund - Energy Select Sector 0.736 0.378 1 - - - - -
XLP SPDR Select Sector Fund - Consumer Staples 0.779 0.645 0.46 1 - - - -
XLV SPDR Select Sector Fund - Health Care 0.805 0.489 0.468 0.716 1 - - -
XLF SPDR Select Sector Fund - Financial 0.847 0.278 0.494 0.6 0.646 1 - -
XLK SPDR Select Sector Fund - Technology 0.908 0.455 0.644 0.672 0.669 0.676 1 -
XLY SPDR Select Sector Fund - Consumer Discretionary 0.916 0.348 0.564 0.689 0.708 0.814 0.831 1
XLI SPDR Select Sector Fund - Industrial 0.944 0.412 0.695 0.702 0.708 0.828 0.816 0.894 1

Source: MacroAxis

Its correlation against other sectors is also low. It has under a 0.5 correlation with the staples and healthcare sectors. Over the long term, the sector also provides excellent returns. Since inception, the sector has produced the highest return as measured by the Sector SPDR funds since inception:

Source: Select SPDR

However, the sector has dramatically underperformed the other sectors over the previous five years, despite last year's stellar rally. Many of these stocks are selling at prices well below all-time highs. Given the stellar long term performance, low cross correlations, and high dividends, an astute investor should consider energy stocks as a key component of their portfolio.

I believe the energy sector is going through a period very similar to that of the financial stocks eight years ago. Although many of these stocks have rocketed off the bottom set last February, we find that the sector has now consolidated since late last year and several firms offer opportunity. That's especially true considering the marked sell-off in early 2017. Despite the fact that the price of oil has remained range-bound between $50 and $53, with the exception of yesterday's plunge, many of these stocks are down by double-digits.

Company Name YTD Change %
Marathon Petroleum -0.26%
Valero Energy -2.12%
Halliburton Co -5.18%
Chevron Corp -6.87%
Schlumberger Ltd -6.97%
ConocoPhillips -8.44%
Exxon Mobil Corp -10.23%
Noble Energy Inc -10.43%
Phillips 66 -10.60%
Occidental Petroleum -12.87%
Marathon Oil Corp -14.10%
Apache Corp -22.15%
Hess Corp -23.15%

Source: Yahoo Finance

The sector, as measured by the Energy SPDR, is down 7.5% already this year. But as the stocks have dropped, the sector has become even more interesting to contrarian investors looking for solid dividend companies to buy. Active managers are also underweight the energy sector. According to Merrill Lynch, under 40% of managers are overweight the sector.

Source: Merrill Lynch

For a review of why the energy sector has suffered more than any other sector in the last five years, it is critical to understand how the industry has evolved since the rapid price declines started. The trouble for the sector began almost a decade ago. Most investors forget that oil hit $140 per barrel back in 2008 and began a new up cycle in investment by all the major energy players. They all enhanced research and development to unearth oil, even in high cost areas like the Artic, oil sands, and in deepwater locations. But new technologies enabled exploration here in the U.S. and production skyrocketed. U.S. crude oil production averaged an estimated 8.9 million barrels per day in 2016, according to the U.S. Energy Information Administration. This is up from the 5 billion barrels just before the financial crisis.

The large increase has been largely due to fracking. Fracking has allowed the U.S. to markedly improve its global production profile, but also has become a large disruptive force that has put many other high cost energy projects on the sidelines. It is the oversupply and technological revolution that ultimately caused a price collapse in the fall of 2014, where oil finally broke $100 and cascaded down to $25 a barrel in early 2016. In addition, Saudi Arabia put pressure by taking lower prices in an effort to put many U.S. fracking firms out of business. Unfortunately for Saudi Arabia and others in OPEC, the strong companies have survived and the costs have come down substantially.

So which energy firms listed above are the most promising for the next five years? In my opinion, it is those firms that are operating in the rich Permian region. The firms operating in the Permian basin (Texas and New Mexico) are becoming the most effective at pulling oil out of the ground at the lowest cost. In fact, these firms that maintain large assets in the Permian Basin are now operating nearly half of all rigs in the United States. Throughout this desperate period of change, only a few companies have been savvy enough to work with new technologies and get rights to the most productive and fertile areas in the Permian.

According to the consultancy firm Wood MacKenzie, nearly 60% of the global oil production that is economically feasible at $60 a barrel is in U.S. shale. Deep water projects only account for 20% of the profitable projects at $60 a barrel. In the past, new large projects undertaken by the major oil firms were nearly 50 per year. In 2016, fewer than 10 new projects were announced. Wood MacKenzie has indicated that average costs per barrel have dropped by over 40% in many shale regions. Companies that operate in the Eagle Ford need an average Brent crude price of $38 a barrel to break even, though this depends on the firm involved and the location of rigs. The Bakken is now closely in line with the Eagle Ford for most companies. Those firms holding assets in the Permian Basin need approximately $30 a barrel to break even.

Five years ago, these numbers were starkly different. The cost of production in Bakken, Eagle Ford, and Permian were $98, $85, and $69 at that time. Statoil SA's (STO) head of U.S operations recently revealed that his firm will be profitable within two years at $50 per barrel, despite the fact that their assets primarily reside in the Bakken, Eagle Ford, and Marcellus regions. Statoil's break-even price for these three regions was $66 per barrel at the end of 2016, a 35% drop from the previous year. If Statoil can drive improvement by this margin in the higher cost regions like the Marcellus, the Permian producers should continue to move breakeven to even a lower threshold.

As this area is now critical in the world of lower oil prices, nearly $30 billion was spent in the past fifteen months for acquisitions in this region. This includes Exxon's (NYSE:XOM) large purchase of 250,000 acres in the Permian, which added 3.4 billion barrels of oil equivalent to the firm's inventory. Occidental, Noble (NYSE:NBL), and Diamondback (NASDAQ:FANG) also had $2-plus deals within the region. It's like the old "Sooner" land grab generations ago. But this time it is corporate America, not individual land owners. In fact, individual land owners like the Bass family, who sold out to Exxon, are the last elements for the oil majors to gain scale in the area.

Most experts see that rig counts within the region could advance by over 100 by the end of the year. Much of the attraction is the areas of large network of pipelines. The Permian region also is close to major areas within Texas and has a better climate than the Bakken. This makes work easier and costs lower. Of the firms listed above, several high-dividend stocks have large exposure to this key Permian region including Exxon, Chevron, and Occidental. Although other firms, like EOG Resources (NYSE:EOG), offer a better growth profile, the dividends are well below the S&P 500 index.

Source: Bespoke

Overall, I find the energy sector very attractive for dividend investors due to the recent price declines. The relative strength chart above shows that the sector is now very oversold vs. the S&P 500 stock index. In fact, it is as oversold as it was last February, which marked the low in energy stocks for the year. My favorite plays at the moment are the high0dividend firms Occidental and Exxon. Apache also stands out given its near 22% drop in price, its solid yield, and improving Permian assets. Apache controls 1,574,000 net acreage in the region in the Midland, Central, and Delaware basins including its new discovery in Alpine High. Alpine High could potentially be a huge production area with 18 wells now in progress. The areas' production could top 3 billion barrels of oil and 75 trillion cubic feet of natural gas.

Exxon also stands out due to its lower beta and outsized dividend yield. Its aforementioned purchase of Permian assets puts the firm in a top position in the area. Exxon Mobil's new CEO Darren Woods, who took over for Rex Tillerson, announced last week the firm was moving fast towards shale. Exxon will now spend a quarter of its 2017 capital budget on shale at a cost of over $5 billion. The new CEO indicated that 5,500 wells are to be drilled and will be profitable at $40 per barrel. Shale may account for over a quarter of total production for Exxon within a decade.

My favorite of the three is Occidental. This is due to the fact it has the highest production in the Permian region and a very generous dividend. I wrote up my complete thesis on Occidental in January. I also like Phillips 66 (NYSE:PSX), a refining firm with a high relative dividend within the sector. My argument for owning PSX was written up in February.

Disclosure: I am/we are long OXY, XOM, PSX.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.