Is XLE A Good ETF To Buy? What To Know Before Deciding

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The Alpha Sieve
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Summary

  • XLE’s risk-adjusted stats and income profile compare rather favorably versus peers.
  • Current market sentiment for oil may not be the strongest but there are plenty of other silver linings to be considered.
  • The valuation and yield component of the majority of XLE’s constituents still look very attractive.
  • The energy sector still offers useful value at these levels but interested investors are advised to pursue XLE at the $40-$45 levels.

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Introduction

The Energy Select Sector SPDR ETF (NYSEARCA:XLE) is widely perceived to be the principal port of call for those seeking exposure to the energy component of the S&P500. This is reflected in an astronomical AUM of close to $23bn, which is more than 4x that of the next biggest peer- Vanguard Energy ETF (VDE). XLE is also one of the oldest, if not the oldest energy-focussed ETF around, with a history of close to 23 years! XLE principally targets oil, gas, and consumable fuel companies, as well as those involved in the sphere of energy equipment and services.

How does XLE compare with its peers?

Since investors have the option of choosing from nearly 30 odd energy-focussed ETFs, it begs the question if XLE seemingly deserves the attention of being the go-to option in this space. I'd like to think so, and XLE certainly behaves like a well-rounded leader that juggles its income angle, risks, and returns adroitly. To present my case, I'd like to compare XLE to the flagship energy ETFs of two of the other largest fund houses in the ETF industry (Vanguard and Blackrock); I'm referring specifically to The Vanguard Energy ETF, and the iShares U.S. Energy ETF (IYE).

Firstly, let's talk returns; the starting point is the 23 rd of September, 2004 as that's when VDE - the ETF with the shortest lifespan of the three - was first listed (XLE began its journey in 1998, IYE in 2000). As you can see from the image below, since that date, XLE has managed to outperform the other two by ~7 and ~15% respectively.

Source: Yahoo Finance

Now looking at long-term returns in isolation won't necessarily provide a comprehensive perspective of the product in question; I also believe it's pertinent to get a sense of the risk involved and how effectively these ETFs juggle their risk profiles to deliver suitable returns. I'd also like to see how these ETFs fare when the chips are down (i.e. downside risk and drawdowns). To get a sense of all this, consider looking at the table below which provides some notable risk-adjusted return stats of the three ETFs over the last 15 years.

Source: Compiled by the writer using data from YCharts

The energy segment is perceived to be an innately volatile segment but XLE fares reasonably well here, even though it is not the least risky. The beta tells us how sensitive the ETF's movements are to the overall market whilst the standard deviation (SD) gives us a sense of the degree of variability of the returns of the ETF; the more variable these returns, the riskier the ETF. In this regard VDE is the one that fares rather poorly. We also know this sector is prone to severe bouts of selling particularly when then the economic cycle turns. Well, out of the three, XLE is the one that has seen the least drawdowns with a max drawdown of 71.26%.

Then crucially, when it comes to the core risk-adjusted return stats, XLE fares the best. The Sharpe ratio gives us a sense of how much excess returns the ETF generates (i.e. return of the ETF over the risk-free rate) relative to the total risk per unit. Here XLE comes out on top. The same goes for the Sortino ratio, which is perhaps more appropriate for the energy sector given the significant downside risk that this sector is typically prone to. For the uninitiated, the Sortino ratio is a sort of refined version of the Sharpe ratio whereby one only looks at excess return generated per unit of downside risk (here we only look at the ETF's standard deviation of negative portfolio returns in the denominator).

Lest I be accused of time-period bias, I've also pasted below the risk/return stats for the more recent 5-year period. Given the smaller sample size, the volatility stats have perked up and have affected the overall Sharpe and Sortino ratios but even here, over this shorter time frame, XLE puts up better risk-adjusted return numbers.

Source: Compiled by the writer using data from YCharts

Essentially the key takeaway from this study is that relative to two of its largest peers, XLE appears to be an ETF that operates most efficiently by not taking on unnecessary risk which doesn't translate into higher returns.

This is also a function of the unique focus areas of these three ETFs. XLE appears to be the most concentrated ETF out of the lot with only 22 stocks in the portfolio (VDE covers 95 stocks and IYE covers 39 stocks); normally I'd be wary of excess concentration, but clearly, this concentration is paying off by way of superior risk-adjusted returns. Besides, there's an enormous focus towards large-cap names (>$12.9bn market cap) as they account for ~97% of the total portfolio, with just a pittance devoted towards mid-caps (XLE's mean market-cap is $43bn and the largest market-cap is $243bn). There is no exposure whatsoever to small-caps ($2.7bn- $600m) or micro-caps (<$600m). IYE's large-cap share too is huge at 91% but like XLE, it doesn't dabble with small-caps or micro-caps. VDE is the ETF that covers all forms of market-cap, yet it appears to have the weakest risk/return profile.

So, the implication here is that in the energy space, you ideally want a portfolio that is predominantly tilted to the big names, and adding small-caps and micro-caps will only likely bring on added risk without generating the requisite returns.

Source: Compiled by the writer using data from ETF.com

It isn't just returns; XLE's income credentials too are top-notch. You currently get to pocket a rather enticing yield of 4.36% which compares very favorably to the median of this asset class which is just 1.18%. IYE only offers 2.94% whilst VDE offers 3.58%. This relatively superior yield angle is not a one-off, but has been a consistent feature as XLE's four-year average has been well in excess of 5%, vs just 3.8% for VDE, and 4.9% for IYE. Also note that on a 5-year CAGR basis, XLE is the only one out of the three that has seen its dividends grow at ~2%; VDE and IYE's dividends are down by -8.3%, and -5% CAGR respectively.

Market commentary

Sentiment for energy assets such as XLE is primarily being driven by what's currently happening in the oil market; the commodity has enjoyed a solid run over the past 12-15 months, but recently we've seen a gradual shift in the supply-demand dynamics which has consequently sullied sentiment. On the supply side, you had the recent decision of OPEC and its allies to restore production by 400,000 barrels a day from August, until the end of 2022. Even before this development, it's also worth noting that supply had been ramping up quite quickly these last few months; last month oil output from OPEC hit 26.72m bpd, up by 610k bpd from June's figure which also makes it the highest level since April 2020. The roadmap for the supply side looks relatively clear, but with the demand side there are plenty of ambiguities and this will likely dictate where the price goes in the foreseeable future.

On the demand side, the recent spread of the delta-variant across the globe has put a spanner in the works for air travel notably. Of particular concern is what's happening in China where the peak summer travel season could be adversely impacted as half the provinces there are now struggling with the latest outbreak. The virus has now reportedly spread to the inland cities and measures are being taken to restrict locomotion whilst businesses there are also suspending services. It's worth noting that even before these developments, global oil demand was expected to hit pre-pandemic levels only by the end of Q4-22. Downstream refining margins of these energy companies could likely stay compressed as the lack of ample jet fuel demand has forced refiners to blend jet fuel with diesel reducing overall margins. Reportedly global composite margins YTD are only~$1.8/bbl, ~57% lower than the 5-year average of $4.25/bbl.

The energy majors still have a lot going for them

Having said that, I also want to state that it's not all doom and gloom for XLE and the energy industry and there are plenty of promising sub-plots to consider that could also tilt sentiment the other way. To present my case, I want to focus primarily on Exxon Mobil Corporation (XOM), and Chevron Corporation (CVX); much of XLE's future performance will depend on how these two fare, as they jointly account for~45% of the total portfolio.

Lately, there's been a cacophony of wails, with crude dipping below the $70/bbl mark. This doesn't necessarily have to be a death knell of sorts and some context is required. Obviously, the energy majors would prefer it if oil stayed above $70/bbl but these companies still have the requisite balance sheet and free cash flow position to chug along, even if crude gets closer to $60/bbl. CVX's FCF levels recently hit $5.25bn, its highest point since Q3-18 and comfortably higher than the 5-year average of $2.3bn

Source: YCharts

With Exxon, the FCF situation is even more solid, with that number hitting record highs of nearly $7bn. This is some serious firepower that can be used in a variety of ways to appease shareholders even if oil prices were to dip.

Source: YCharts

I would also argue and say that some price correction is healthy and will help these companies make better capital allocation decisions as there will be less incentive at lower prices (Lower prices also dampen the ferocity and incentive of widescale electrification transition plans, and also give these energy majors more time to carry out their own transition into low carbon avenues). During previous boom cycles, these companies got carried away with high prices and burnt cash in sub-par expansion activities or unprofitable drilling and production activities.

Once bitten, twice shy and all that, and as a consequence, we've seen them change tack with their capital allocation plans. For instance, in H1, CVX had curtailed its C&E (Capital and exploratory) expenditures by 32% and they've also lowered their FY organic C&E guidance to $13bn. Meanwhile, OPEX costs are on course to be ~10% lower than 2019 levels.

Source: Chevron Q2 presentation

I recognize that a lot of investors would like to see these companies direct the excess free cash flow by way of higher dividend payouts, but I'm not sure they will resort to that, given what it could do to future sentiment if this were to be curtailed when prices dip; the more prudent thing would be to resort to buybacks or deleverage the balance sheet and that's what we're seeing with both CVX and XOM.

CVX which had previously cut its buyback plans last year has now reinstated this and plans to do about$2-$3bn a year regardless of the market cycle. With XOM, I've been very enthused by their deleveraging plans, in H1-21 alone they've paid back debt to the tune of$7bn and that heightened net debt position that crossed$60bn last year, looks a lot less daunting.

I feel it's important to measure these stocks not just purely from their correlation to oil prices but also other factors. Consider something like the shareholder yield which is a function of the dividend yield, the buyback yield, and a debt paydown yield. For both XOM and CVX, the current shareholder yield is at record highs of 10% and 8% respectively and for XOM it is almost twice the 5-year average.

Source: YCharts

Source: YCharts

Also note that these companies have other lucrative divisions where the prospects look very bright. For instance, XOM's chemical division recently posted its best-ever quarterly earnings as the company continues to benefit from tight supply-demand conditions in the polyethylene markets of North America and Europe which have sent margins through the roof. Demand for these products has been very strong from industries such as hygiene, packaging, and durable goods and it doesn't look like it will fade particularly with the former two.

Source: Exxon Q2 PPT

Valuations and yield picture

In this section, I also want to reiterate the attractive valuation picture of the majority of XLE's constituents. I've focussed on the top-10 stocks of XLE as they jointly account for an outsized weight of ~78% of the total portfolio and will pretty much dictate how XLE fares.

Firstly, I wanted to get a sense of the valuations from a core operating position relative to the enterprise value, so I've looked at things from a forward EV/EBITDA basis. The two biggies (XOM and CVX) currently trade at a -15-28% discount to the long-term forward EV/EBITDA multiple. For the rest of the pack, with the exception of Marathon Petroleum Corporation (MPC) and Phillips 66 (PSX), the discount varies from anywhere between 8% to 51%.

Source: Compiled by the writer using data from Seeking Alpha

Then, I've highlighted previously how the cash position is fundamental to investors' perception of this sector. We know that XOM and CVX are in a very healthy position, cash-wise, but even the other 8 stocks are trading at price multiples that are not reflecting the impressive forward cash dynamics. For Kinder Morgan (KMI) and The Williams Companies (WMB) I could not source the 5-year average of the forward P/CF multiple, but alternatively, do consider that even on a trailing P/CF basis, the former trades at a ~18% discount to its long-term trailing average; the latter, on the other hand, trades at a premium of ~10% over its trailing 5-year average.

Source: Compiled by the writer using data from Seeking Alpha

Finally, I recognize that a lot of investors gravitate to the energy sector for its income component, so I also thought it would be pertinent to look at things from the dividend yield perspective. The table below shows that, with the exception of Schlumberger Limited (SLB), all these other stocks are currently offering rather attractive yields that are better than the historical average.

Source: Compiled by the writer using data from Seeking Alpha

All in all it's fair to say that from a valuation and income angle, the constituents of XLE still look rather appealing.

Closing thoughts

I would like to finish this article by shifting focus towards the relative price action and the standalone price action.

The first chart gives us a sense of how over-sold energy stocks look relative to the S&P500. Since the GFC, this energy to S&P500 ratio has been trending lower in the shape of a descending channel. During last year's carnage, this ratio collapsed outside the channel (the blue ellipse) but manage to recoup the channel earlier this year. Energy may not necessarily provide the multi-year leadership that tech has given the S&P500 these last few years, but there is value on offer here. Admittedly the ratio is no longer at record lows but it is still a long way from the upper boundary of this channel (closer to 0.25x) which implies that the risk-reward is still fairly attractive.

Source: Stockcharts.com

If I narrow the lens down to just the standalone price action of XLE there are two big-picture themes to note; firstly, for much of its life, XLE's mean reversion zone or comfort zone has tended to be somewhere between the $50- $80 range. (the red rectangle area). Secondly, since peaking in 2014 the price imprints have predominantly been in the shape of a descending channel. After an uptrend since November 2020, XLE is currently in the midst of undergoing its first bout of correction, whereby it is clinging to the lower edge of the price balance zone.

Source: Trading View

The relative strength chart above has shown there's potential value on offer but given the long uptrend of XLE since late last year, it would be more prudent to wait for a retracement back to the $40-$45 levels (yellow rectangle area) which had previously served as a key pivot point during 2005, 2008/2009, and H2-20. At those levels, I would look for XLE to build some sort of base before getting in. The ideal exit point would be closer to the upper boundary of the channel, or the $57-$60 levels.

To conclude, there's a lot to appreciate about XLE, but sentiment for the energy sector isn't particularly resplendent at the moment, and this could push XLE down to more favorable buying levels, closer to the $40-45 zone. Until then, I'd prefer to sit on the fence. Neutral.

This article was written by

The Alpha Sieve profile picture
1.39K Followers
Investment research, primarily oriented towards uncelebrated/under-covered stocks and ETFs, across North America, Europe and Asia. Seeks to combine both fundamental and technical disciplines while making an investment/trading proposition.
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Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. 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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