We have lightened up on our aggressively overweight position on Energy Select Sector SPDR ETF (NYSEARCA:XLE) in recent months after seeing an 80% rally from its October lows when we noted that the index looked set to double over the next 12 months (see 'Oil Stocks: Peak Herd Mentality'). However, we continue to hold an overweight position for several reasons noted below. The tendency for oil and major oil producers to act as an inflation hedge is a major benefit of the sector.
XLE offers a very efficient means of gaining exposure to the oil sector, with an expense ratio of just 0.12%. As well as gaining exposure to a rising oil prices, XLE also offers some safety relative to other oil ETFs due to the high weighting of revenues coming from chemical and refining operations.
US Inflation Expectations Vs Oil Prices And Oil Stocks
1) The Oil Sector Is Among The Best Inflation Hedges Available
There are no other assets that are as closely linked to inflation expectations as oil and oil stocks. The following chart shows the rolling correlation between U.S. 10-year inflation expectations as measured by the bond market with various other assets. Crude oil and XLE have by far shown the closest correlation over the past decade.
Despite ongoing efforts to decarbonize the planet, the relative ease at which oil can be stored and its inelasticity of demand across the entire production process of almost every finished product available mean that it continues to be a barometer for U.S. and global inflation expectations. As an aside, based on the historical correlation with inflation expectations, both oil and XLE look undervalued.
2) The Sector Is Still Relatively Cheap
XLE's underlying MSCI U.S. Energy sector continues to trade at a deep discount to its fair value based on the historical relationship with oil prices and U.S. equities. The following chart shows the MSCI U.S. Energy's share of the MSCI U.S. Index against the inflation-adjusted oil price going back to the late-1990s. Based on the correlation, the energy sector's share of the total U.S. equity market capitalization should be closer to 8% than its current 2.5%.
Of course, we cannot put too much weight on a single chart as there are genuine reasons why energy stocks have underperformed beyond the oil price itself. However, despite these fundamental developments, the oil price continues to dictate profitability and the cash flow of the majors continues. Even with the recent correction in WTI, the Bloomberg analyst estimate for free cash flow yields over the next 12 months is 7.5% compared to the MSCI U.S.' 3.7%.
3) The Dividend Yield Remains Attractive, Particularly Considering Low Default Risk
Expectations of a strong recovery in free cash flows explain why managers decided to maintain their high dividend payouts in the face of last year's oil price weakness. Dividends have only fallen 8% from their peak allowing XLE's dividend yield to remain high at almost 4.2%. This 4.2% yield is hard to come by these days without taking on a high degree of default risk. When we consider that the default risk on Exxon and Chevron (the two largest components in XLE making up almost 45% of the index) is virtually zero according to the bond market, this makes the current yield even more attractive. The spread of Exxon's 10-year bonds over equivalent U.S. Treasuries is currently just 60bps while Chevron's is 54bps.
4) Oil Consumption Could Hit New All-Time Highs This Year
For all the talk of peak, oil demand data from the countries less impacted by Covid lockdowns show that oil consumption is back at new all-time highs. China posted new all-time high crude oil and liquid fuel consumption in December, while the rest of Asia excluding Japan saw consumption rise to within a whisker of all-time highs in February.
Even in the OECD, oil consumption is only 8% below its 2019 peak. As economies gradually reopen and air travel resumes, OECD oil consumption is likely to rise sharply, offsetting the impact of decarbonization policies. With Asian demand likely to continue to rise to new highs, total global oil consumption looks set to resume its long-term trend to record levels.
There are of course downside long-term pressures on oil consumption from electric vehicles but there are also upside risks. Perhaps the biggest upside risk comes from the increased tendency of developed market governments to adopt infrastructure spending as a means to boost growth, enabled by ongoing Fed money creation.
With these factors in mind, we see XLE as a strong risk-reward play which allows investors to benefit from a continued rise in inflation pressures while paying an attractive dividend and offering a degree of diversity in terms of revenue streams. The Oil & Gas Refining and Marketing sector comprises 58% of the XLE for instance, while Exploration and Production makes up 23% and Transportation and Servicing make up the remaining 19%. With an expense ratio of just 0.12%, total returns are likely to considerably outperform crude oil itself particularly considering the contango in the oil market.