Over the past two months we’ve been discussing the energy sector. In part one, we considered the significant role energy plays in society and explored some of the various energy sources (What You Need to Know Before Investing in Energy). Last month we explored the risk-return profiles of energy investments using mutual funds and ETFs (Energy Part 2: ETFs and Mutual Funds).
In this article, we’ll examine this beaten-down sector and look at issues that should be considered before investing (and a warning, I researched and wrote this piece before the week of August 17-24, when the markets swooned).
As Sir John Templeton once remarked, “Buy when there’s blood in the streets.” I would add that it’s best to wait until the patient is stabilized.
The Energy Sector in Review
There are a number of ways to parse the energy sector. Here is a list of industries and their average market cap as a percentage of the entire energy complex.
- Oil & Gas Drilling (1.5%)
- Oil & Gas Exploration & Production (21.1%)
- Oil & Gas Equipment & Services (8.8%)
- Oil & Gas Integrated (44.9%)
- Oil & Gas Midstream (17.6%)
- Oil & Gas Refining & Marketing (6.0%)
The average market cap of this group has declined nearly 28% from one year earlier. The earnings yield over the trailing 12 months for energy stocks is 5.75%, with Oil & Gas Drilling and Oil & Gas Refining and Marketing leading the way at 11.26% and 9.99%. respectively. However, these high-yielding components are the two smallest industries within the sector, comprising only 7.5% of total market cap.
Energy stocks are highly sensitive to oil prices, which have fallen from over $107 per barrel in mid-June 2014 to less than $43 today. As a result, the carnage in the energy sector has been severe. The following chart shows the number of energy stocks that have fallen by various percentages over the previous 12 months. For example, 107 stocks declined by 90% or more, 91 lost between 80% and 90%, 127 companies lost between 70% and 80%, and so forth.
Over 90% of all energy company stocks were negative for the trailing 12 months and 52% of them lost 50% or more. This definitely qualifies as blood in the streets. The question is, should you buy an individual stock or a packaged product such as a mutual fund or ETF, or an MLP? Much of this depends on your appetite for risk.
Energy ETFs, mutual funds, and individual energy stocks are all sensitive to oil prices, but if oil continues to fall, a fund might fare better than an individual security. The following table contains data on three large-cap energy funds.
It’s interesting to note how the Vanguard mutual fund has the smallest average market cap, the most foreign exposure, and the lowest return of the three. It also has the highest correlation to oil prices, which may be related to its smaller market cap. In other words, a larger company may be less sensitive to oil prices, especially if it has a more diversified income stream.
This sector is certainly on sale. But is it time to get in?
Tips to Consider Before Buying