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Is Now the Time to Buy Energy Stocks?

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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.

Number of Energy Stocks wtih Negative Trailing 12-Month Returns

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.

 How Sensitive to Oil Prices Are Energy Investments? A Tale of Three Mutual Funds

This sector is certainly on sale. But is it time to get in?

Tips to Consider Before Buying

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.

Fear in the Oil Market

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. 

Stock Losses by Market Cap

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.