Is Now the Time to Buy Energy Stocks?

If you’ve been investing for any length of time, you’ve probably learned that buying a security just because it has fallen is not always prudent. Here are some things to consider before pulling the trigger.

First, given the sector’s high correlation to crude oil and the abundant supply of it versus weak global demand (due in part to a slowing global economy), it may be wise to wait. If oil prices continue to slide, further stock declines are likely.

Second, this particular bull market has lasted much longer than the average bull. Is it getting weary? Perhaps this recent decline is signaling an approaching correction? If so, energy stocks will likely follow the broader market.

Third, watch the level of fear in the oil market, as measured by the Oil VIX, which was launched May 10, 2007. Similar to the overall VIX, which gauges fear in the broader stock market, the Oil VIX measures fear in the oil market. The following graph contains the Energy Spider ETF (XLE) and the Oil VIX (orange line) from its inception May 10, 2007 to August 13, 2015.

During the first 13 months or so, XLE rose despite increasing fear. There was a high correlation (0.69) between the two during that period (May 10, 2007 to June 24, 2008). From that point forward, the correlation was more like what you would expect at -0.68. As of August 13, 2015, the Oil VIX was at 43.23, slightly above its average from inception of 36.42. The correlation between the Oil VIX and the traditional VIX is very high at 0.82. Hence, if the Oil VIX rises, it could trigger a selloff in the broader market. Getting back to our question: Is it time to buy energy stocks? 

3 Rules for Investing in Energy

If you believe that now is the time to invest, here are things to consider: 

Rule #1: Be patient.
The opportune time will come. How will we recognize it? Energy stocks tend to do well late in the business cycle. The most recent recession ended June 2009. However, because this recovery has been the slowest in the post-WWII era, it’s difficult to say exactly where we are in the cycle. Another issue to watch is the price of oil.

While the price of crude doesn’t necessarily need to rebound, it does need to stabilize. I don’t see that occurring until supply and demand reach some sort of equilibrium. Some combination of a strengthening global economy and a cut in production is needed. If you’re planning to invest in individual stocks (as opposed to a fund), here’s another consideration.

Rule #2: Buy companies with a well-diversified income stream.
Referring to the six industries listed above, Oil & Gas Integrated companies meet this standard. These companies are involved in exploration, drilling and retail. They are generally less risky than entities that derive 100% of their income from drilling. 

Rule #3: Buy larger companies.
Larger companies tend to have a greater ability to withstand adverse market conditions such as a recession or a collapse in oil prices. Conversely, smaller companies tend to lose more when things get rough. The following table substantiates this claim. 

The average market cap of energy companies that lost 90% or more during the previous 12 months is $22 million. Companies that lost 80% to 90% have an average market cap of $109 million. The larger the market cap, the less the decline. The average market cap for energy companies losing 50% or more is $625 million. This makes a compelling argument to buy the large blue-chip names.

Although the worst of the carnage may be over, it may still be a little early to invest in this sector. When supply-demand and the global economy improve, some exceptional investment opportunities will emerge. The recent collapse in energy stocks is reminiscent of the broader decline in 2008. Hence, a well-timed investment in this beleaguered sector could prove quite profitable. Perhaps you missed out on the astonishing rebound after the market bottomed in March 2009.

There’s no reason to miss the golden opportunity this time.