VDE: Don't Worry About Short-Term Oil Price Weakness
Summary
- The Vanguard Energy ETF has come under pressure in recent days amid a sharp drop in crude oil prices, but this should be little cause for concern.
- The performance of oil majors relative to the overall stock market tends to be driven more by the price of oil long into the future than by front month prices.
- Even with long-dated oil futures at current low levels, the energy sector’s share of the S&P 500 should be roughly double its current level if history is any guide.
- This undervaluation is reflected in the VDE’s sizeable dividend yield, which should remain highly attractive unless we see a strong rally in the ETF.
The Vanguard Energy ETF (NYSEARCA:VDE) has come under pressure in recent days amid a sharp drop in crude oil prices, but this should be little cause for concern. The performance of oil majors relative to the overall stock market tends to be driven more by the price of oil long into the future than by front month prices. Based on data over the past two decades, which has a correlation of 0.9, U.S. energy stocks remain more than 50% below the level implied by long-term crude oil prices. The VDE should benefit as this undervaluation over time as current oil prices allow dividend payments to remain significantly higher than the overall market.
The VDE ETF: More Diversity Than XLE But A Lower Yield
VDE seeks to track the performance of U.S. energy stocks as classified by GICS. The fund diversifies its holdings by applying limits on regulated investment companies using the MSCI 25/50 methodology, such that no group entity exceeds 25% of index weight and the aggregate weight of issuers with over 5% weight in the index are capped at 50% of the portfolio. As a result, the VDE is slightly more diversified than the larger Energy Sector Select SPDR ETF (XLE), with the two largest companies, Exxon and Chevron, comprising 38% of the index versus 45% for the XLE. Meanwhile, the top 10 companies make up 67% of the index versus 78% for the XLE. This diversification comes at the cost of a slightly lower dividend yield of 3.7% versus the XLE's 4.4%. The VDE also has a slightly lower expense ratio at 0.1% versus 0.12% for the XLE.
Long-Term Oil Prices Suggest VDE Is 50% Undervalued
In previous articles on the U.S. energy sector I have sought to show how oil majors are deeply undervalued relative to the overall market based on current oil prices. In 'XLE: Remains Extremely Cheap Vs. SPX' I ran a chart which showed the energy sector's share of total U.S. market cap versus front month WTI crude oil prices relative to GDP. The 19-year r-squared between the two ratios sits at 0.75 reflecting the strong tendency for oil prices to determine relative energy sector performance. I have updated the above chart by replacing front month WTI with 3-year WTI futures prices, shown below.
Source: Bloomberg, Author's calculations
It turns out, perhaps unsurprisingly, that the correlation is much stronger, with an r-squared of 0.9. Based on this correlation, the market cap of U.S. oil stocks is currently over 50% below fair value. Given the incredibly tight correlation, this degree of undervaluation represents a three standard deviation occurrence. U.S. oil equities are now more undervalued relative to the overall market than they were overvalued at the very height of the global financial crisis.
Near-Term Oil Price Decline Would Not Undermine VDE's Appeal
With this in mind, holders of VDE need not be too concerned about near-term oil price fluctuation, particularly when front month prices are so elevated relative to the long-end of the curve. The price of WTI to be delivered next month is currently 23% higher than the price of WTI to be delivered in 3 years, and what matters for energy stocks is the behavior of the latter not the former. While renewed economic weakness may well undermine long-dated oil futures, they are already deeply depressed relative to the broader commodity complex, and the long-term consumption outlook remains much brighter than most expect (see 'XLE: More Upside To Come Amid The Bright Oil Consumption Outlook').
3-Year WTI Futures Vs Bloomberg Commodity Index
Source: Bloomberg
VDE Dividend Yield Likely To Remain Highly Attractive
From the perspective of the VDE, the energy sector's relative undervaluation in the context of the overall market and current long-term oil futures means that investors can expect relatively high dividend yields to continue absent any strong recovery in the ETF. The VDE currently yields 3.7%, almost triple the Vanguard S&P500 ETF's 1.3%. The forward dividend yield on the underlying MSCI Energy Index is even higher at 4.6%, while the forward free cash flow yield is an incredible 9.7%. At current oil prices, we should expect to see the VDE's dividend yield increase further unless the ETF rallies significantly.
Summary
Weakness in near-term crude oil futures does not pose much of a threat to the positive long-term outlook for U.S. energy stocks, which tend to be driven more by long-term oil futures. Even with long-dated oil futures at current low levels relative to short-dated futures and the broader commodity complex, the energy sector's share of the S&P500 should be roughly double its current level if history is any guide. This is reflected in the VDE's sizeable dividend yield, which should remain highly attractive unless we see a strong rally in the ETF.
This article was written by
Analyst’s Disclosure: I/we have a beneficial long position in the shares of VDE either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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Energy-----------------22----------------20.20----------(-18.70)
Financial Services--69--------------- 21.90----------15.00
Consumer Def-------35---------------- 27.70----------26.70
Utilities-----------------28-----------------30.30----------26.60
Industrials-------------73-----------------32.20----------69.00
Basic Materials------21-----------------37.90-----------30.80
Healthcare------------65------------------38.80----------35.00
Technology------------71------------------48.80---------35.50
Comm Services------26------------------53.70---------35.90
Real Estate-----------29--------------------56.90--------62.00
Consumer Cyclical--66-------------------58.90---------71.60
S&P 500---------------500------------------38.6-----------34.5Source: www.gurufocus.com/...
