Don't Get Burned By Energy

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Includes: SCO, XLE
by: Alex Gurvich

This year was not kind to investors in the energy sector. And what's worse, it is not likely to get any better. Slowing world economies and a lack of frightening war headlines keep energy stocks down. But there are ways for investors to make money from this.

How far down are oil and other energy producer stocks? Energy is the worst-performing sector year to date, as measured by the Energy Select Sector SPDR (NYSEMKT: XLE) from State Street, with negative 7.1% for the year and severely underperforming the S&P 500 ETF (NYSEMKT: SPY) by 13.34 percentage point. In fact, the energy exchange-traded fund is the only Standard & Poor's 500 sector to lose money in 2012.

Sector

Ticker

YTD Return

Pct. Pt. Different from SPY

Technology

XLK

10.79%

4.88

Discretionary

XLY

10.66%

4.75

Financials

XLF

10.00%

4.09

Healthcare

XLV

8.10%

2.19

Staples

XLP

4.71%

-1.20

Industrials

XLI

2.36%

-3.55

Materials

XLB

2.33%

-3.58

Utilities

XLU

1.89%

-4.02

Energy

XLE

-7.43%

-13.34

SPY

5.91%

0.00

S&P

6.06%

-1.20

As of June 26, total return.

What a difference a year makes. Last year, for the January-to-May period XLE was the second best sector and a top sector for many months before that. What happened? Is the sector oversold?

The most basic reasons for poor sector performance come from the fundamental demand perspective. Simply speaking, much of the world is in recession or close to it, and the energy demand is lower. Oil is trading below $80 per barrel, quite a bit cheaper than year ago. Although the U.S. economy is improving somewhat, the downturn in Europe and slowdown in China are the key influences hurting the energy sector.

There are several additional factors in play that should not be overlooked. One is the continuous infighting among Organization of Petroleum Exporting Countries members regarding level of production, while the other is the possibility of military conflict with Iran.

Within OPEC, Saudi Arabia and other moderate oil producers are trying to keep the prices stable without shocking the world economies even further. Opposing them is a group seeking to push up prices. Led by Iran and Venezuela, it is trying to decrease production, which makes oil scarcer and thus pumps up its price. The good news, so far, is that the Saudi Arabia block is winning and we will most likely see continued stability of supplies.

On the other hand, the chances for a possibility of military conflict with Iran have increased since the negotiation between the US and our allies and Iran have pretty much broken off. If there is a conflict, the oil prices will sky rocket.

So overall we have a lower world demand, with stable supply, which can potentially keep the oil prices at the same level or lower, but an uncertainty of political-military events raise a possibility of a singular oil price spike.

The odds are that most likely the oil prices will continue to drift down, with a very small chance of an upward spike.

As a conservative investor, I say stay away from this sector until there is better clarity on the demand side. If you are more aggressive investor, you can short the XLE. For the truly adventuresome, there's a double inverse oil ETF, which pays the opposite of what the market does, by two times, twice what an inverse ones does, such as the UltraShort DJ-AIG Crude Oil (NYSEMKT: SCO).

For someone who wants to live dangerously and play the geo political events, in case of a military conflict with Iran, putting a small allocation to XLE would serve well.

Disclosure: I am short XLE.