XLE ETF: Crude Rally Points To Further Gains

Summary

• Even after a more than doubling in the XLE over the past 12 months, the rise in oil prices suggests the bull market has much further to go.
• The XLE appears to be tracing out an inverse head-and-shoulders reversal pattern relative to the SPX.
• The surge in WTI suggests that the energy sector should be more than double its current share of the S&P 500 based on the long-term correlation.
• The tendency for oil majors to benefit during periods of economic turmoil caused by renewable supply shortages adds to the benefits of holding the XLE.

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The Energy Select Sector SPDR ETF (NYSEARCA:XLE) has risen 20% off of last month's lows, posting new highs in total return terms thanks in part to the strong contribution from its dividend yield. Even after a more than doubling in the ETF over the past 12 months, the rise in oil prices suggests the bull market has much further to go.

I continue to see the XLE doubling relative to the SPX over the coming years as the current extreme valuation divergence mean reverts. While this could occur via a 50% decline in the SPX, the XLE's dividend yield is likely to result in strong long-term gains in absolute terms, even if we see a bear market in U.S. stocks. As the chart below shows, the XLE appears to be tracing out an inverse head-and-shoulders reversal pattern relative to the SPX, something I first highlighted in May (see 'XLE: New Highs And Still Cheap').

Ratio Of XLE To SPX (Log Chart)

Source: Bloomberg

The XLE ETF

The XLE tracks the performance of the Energy Sector Select Index, which itself tracks S&P500 components involved in the development or production of energy products. After expenses, the ETF currently yields 3.9%, having fallen over recent months due to price gains. The yield remains above the 3.7% yield on the Vanguard Energy ETF (VDE), reflecting the higher yields on the two major components of the index, Exxon, and Chevron, which have a higher weighting in the XLE. These two oil giants have a combined weighting of 43% in the XLE, although has fallen from above 50% during the height of the COVID crash of 2020 thanks to the stronger recovery seen in the smaller companies in the index.

XLE Still >50% Below Fair Value Relative To SPX And Oil Prices

Even after such a large rise in the XLE, the ETF remains more than 50% below its fair value when measured against the price of crude oil and the overall U.S. market. While the XLE's underlying Energy Sector Select Index has risen sharply over the past month and the SPX has declined, the surge in WTI suggests that the energy sector should be more than double its current share of the S&P500 based on the long-term correlation.

Source: Bloomberg, Author's calculations

The relative undervaluation of the Energy Sector Select Index shown in the above chart corresponds with the forward-looking valuation metrics shown in the table below. In fact, the average valuation discount is now greater than it was in July (see 'XLE: Remains Extremely Cheap Vs. SPX',) as the surge in oil price has seen forward estimates of energy sector sales, earnings, and cash flows rise much faster than those of the SPX.

Forward Valuation Ratios Based On Bloomberg Estimates

	SPX	XLE	XLE % Discount
				Price/Earnings	21.4	16.9	21.0
EV/EBITDA	14.5	7.4	49.0
Price/Sales	2.8	1.1	60.7
Price/Free Cash Flow	25.8	10.8	58.1
Price/Book Value	4.3	1.9	55.8
Price/Dividend	71.4	24.9	65.1
Average			51.6

Click to enlarge

Source: Bloomberg

Energy Shortage Highlights The Difficulty In Reducing Fossil Fuel Usage

The recent surge in global energy costs is a stark reminder of the difficulty the world faces in trying to wean itself off of fossil fuels and supports my view that peak oil demand is more of a pipedream than a realistic scenario. While there are many factors driving the current rise in energy costs, and the International Energy Agency has been quick to note that Green policies are not the root cause, there is little doubt that the unpredictable nature of renewable energy, and in particular the difficulty in storing this energy, have had a role to play. The risk is that continued high energy prices will make it increasingly difficult for governments to continue pushing for a renewable energy transition.

From an investment perspective, the tendency for oil majors to benefit during periods of economic turmoil caused by renewable supply shortages adds to the benefits of holding the XLE. I would not be surprised to see energy stocks trade at a premium to the overall market as was the case prior to the past decade as they offer the added benefit of potentially performing well during periods of economic weakness.

Analyst’s Disclosure: I/we have a beneficial long position in the shares of XLE 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.