Playing the contrarian with energy
The sector has been lagging the S&P 500. Its relative underperformance may present an opportunity for investors.
By Nick Kalivas
Sometimes, I like to play the contrarian. A friend once told me nobody builds a statue to a crowd, and being a hero with your investments sometimes requires zigging when everyone is zagging.
The energy sector has been lagging the S&P 500 ($INX). Its relative underperformance may present an opportunity for outperformance if you think sector returns mean revert over time.
What is relative performance?
Relative performance measures the returns of a stock or sector against another stock, sector, or market index. Relative performance is usually measured either by comparing returns over time or on a spread basis using a ratio of the assets being compared. Institutional investors and hedge funds tend to focus more closely on relative performance than retail investors.
How much has the energy sector been lagging:
The ratio of the Select Sector SPDR Energy Fund (XLE) to the S&P 500 ETF (SPY) is trading near the lower end of its five year range. The performance is even worse for the iShares Global Energy ETF (IXC). The ratio of the IXC to the SPY is at its lowest level since 2007 due to the outperformance of U.S. stocks relative to international equities.Between December 31 2012 and July 19 2013, SPY has posted a return of 18.8%, while the XLE has recorded a return of 17.2%. The IXC is up only 6.8% and a clear laggard. Much of the energy sector's poor relative performance came in 2011 and 2012. Investors have been more interested in financial and retail shares this year. The SPDR Financial ETF (XLF) and SPDR Retail ETF (XRT) were up 27% and 29.6% respectively year to date through July 19.
Global energy demand has been slow and refiners pressured:
Energy shares have been pressured by slower global growth, especially the weaker tone of growth in the emerging world in places like China, India, and Brazil. The International Energy Agency, IEA, has global oil demand growing 1.1% this year to 90.8 million of barrels per day and 1.3% next year to 92.0 mbd. Political and social unrest in Egypt and Syria has not been a clear benefit to energy equities on a relative basis.
U.S. refiners have been hurt by a narrowing of the WTI/Brent oil spread (higher input costs relative to output costs) and the increased cost of blending credits for renewable fuels. These factors are out in the open. Valero (VLO) and Marathon Petroleum (MPC) recently lowered earnings guidance.
However, there are a few bright spots for the energy market:
All is not negative for the energy sector. Crude oil prices have been rising in recent weeks and are generally improving the outlook for company profits outside of the refining sector. West Texas Intermediary has risen over $15 a barrel since late June, while Brent prices are up around $8 a barrel. Although some of the gain is being blamed on an unwinding of the Brent/WTI spread, there are fundamental drivers at work.
First, China's apparent oil demand rose 4.8% month-over-month and 11.7% year-over-year in June to 9.99 mbd. Chinese demand for oil may be starting to improve.
Second, the glut of West Texas Intermediary crude oil in storage seems to be loosening with the recent draw in inventory. In recent weeks, WTI inventories have fallen 27.1 million barrels from their high. A decline this time of the year is normal, but the drop has been strong to the five year average. Seasonally, WTI inventories should be pressured into the late summer or early fall.
Third, U.S. refinery run rates have been hot. Refinery utilization was 92.8% at last measure and well above the 88.0% recorded at the same time last year. Demand looks healthy.
Fourth, hot weather has helped to reduce natural gas inventories which stood about 1% below the five year average in the week ending July 12.
Fifth, energy service providers are optimistic. It may be fair to say that if the service providers are seeing healthy growth, the energy industry is profitable. Energy producers don't buy services unless they are intent on extracting and drilling for product. Oil service names Halliburton (HAL) and Schlumberger (SLB) posted positive earnings surprises in the second quarter.
HAL made the following comment in its second quarter press release: "We continue to be optimistic about Halliburton's performance for the remainder of 2013, our ability to continue growing our North America margins, and continued revenue and margin expansion in our international business." HAL also has a $5 billion stock repurchase plan in place.
In its second quarter report, SLB said "As a result, we continue to see consistent growth as spending plans are confirmed by rig count outlooks and customer activity. We remain confident in the industry outlook, our strategic positioning in the markets in which we operate the strength of our technology portfolio and in our ability to further improve our overall performance."
What are some risks?
There is a lopsided large commodity fund long in WTI crude oil futures. The latest data from the Commodity Futures Trading Commission displayed large funds long 467,613 and short 88,248 futures and options contracts in the week ending July 16. The net long expanded nearly 27,000 futures and options contracts. Funds have been buying aggressively in recent weeks. A decline in oil prices could dampen the outlook for energy shares.
Investors may be using the Master Limited Partnership, MLP, sector to exploit opportunities in the energy sector. Investors may be seeking potential tax advantages and attractive yields in form of returned capital, while believing that MLP are more stable than straight equity. Many MLPs act as tollways charging a fee for the use of their pipelines and storage facilities. As a result, they are less sensitive to energy price swings than many other energy sector names.
Global growth is slow and crude oil prices have seen a sharp run up in recent weeks.
Valuation looks cheapest internationally:
The table below displays the price-to-earnings ratio based on forward 12 month earnings for the top five weights in the IXC. Notice that U.S. firms display the richest values given that their forward price-to-earnings ratios are above the 10 year median value. Furthermore, dividend yields on the non-U.S. companies are much higher than the dividend yields on the U.S. companies Exxon Mobil (XOM) and Chevron (CVX).How to seize the opportunity?
There are a few ways to try to exploit the energy sector's underperformance. Here are some ideas:
First, one could buy the iShares Global Energy ETF (IXC) and the Proshares short S&P 500 ETF (SH) at an equal dollar value weighting. At current prices, the ratio is about 1.46 SH to 1.0 IXC. Essentially, this position would leave an investor long energy names against the S&P 500. The position would make money if energy stocks started to outperform the S&P 500. The opposite, of course, is not true. A continuation of the current trend would be a money loser. You have to be a strong contrarian to play this game. It is not for the faint of heart.
Second, the table indicated that international integrated oil names offer attractive dividends and relatively low price-to-earnings ratios to their U.S. based counterparts. BP (BP) or Royal Dutch Shell A Shares (RDS.A) may be worth a look. Both are Zacks rank #3 ("hold"). Total (TOT) is a Zacks rank #4 ("sell") and is less attractive based on the Zacks methodology.
Third, there are Zacks rank #1 ("strong buy") in the energy sector. Gulfmark Offshore (GLF) is a Zacks Rank #1 in the energy service sector. The ESP (Expected Surprise Predication) for GLF stands out with the most accurate earnings per share estimates for 2013 and 2014 well ahead of the Zacks Consensus Earnings Estimates. W&T Offshore (WTI) is an independent oil and gas producer. It is a Zacks Rank #1 and jumped from a Zacks Rank #3 a week ago. GLF and WTI provide a way to invest in energy companies that are seeing upward earnings estimate revisions, while trying to play for a stronger relative performance in the overall energy sector.
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