What To Own?
The oil price is up 40% over the past year. Yet, oil and gas companies appear as the cheapest global sector today, despite being the second best performing of all global sectors over the past 6 and 12 months. As will discuss, there are several reasons to own energy stocks as part of your portfolio right now.
The Evidence For Energy Stocks Appearing Inexpensive
Energy companies are among the cheapest across many valuation methods, in fact whichever method you use oil is among the cheapest sectors and that’s based on historical earnings, mostly from 2017, now the oil price is higher in 2018.
On an individual level too, these companies must follow an SEC rule where they annually disclose the expected value of their energy production over the next 10 years at current prices (something called PV-10). Many companies trade at a discount to this valuation, which is surprising because the PV-10 value can translate into a pretty conservative price to earnings ratio of around 8-12x depending on expected growth rate and how much debt the company has. In contrast, the overall S&P 500 is currently on a PE ratio of 25x, so the broader market is a lot more expensive. Finally, PV-10 values may currently be understated. This is because many companies reported them back in December 2017 when oil was just over $50 a barrel and now it’s a little under $70. If oil stays around these levels, then energy companies may appear even cheaper when the December 2018 numbers are calculated and shared in the first part of 2019.
Another way to think about this question is the last time oil was around $70 was late 2014. At that time the price of a popular oil and gas company ETF (Energy Select Sector SPDR ETF) was 7% lower than it is today, and at that time, oil prices were plummeting.
Other Angles To Consider
Now, as always with investing things are never quite that simple. There are few things we should take note of. First off, energy spans both oil, gas and other hydrocarbons. Though oil is on a very positive trend; gas, which is much more of a regional market given transportation complexities, is currently down year-on-year in the U.S. Secondly, the oil futures curve does show prices moderating in future years, called backwardation, into the mid to low $60s per barrel. So not a massive drop, but still the futures market anticipates some softening in prices. Yet, this is not usual, as treating the futures market as a prediction of future spot prices can be misleading according to Federal Reserve research.
There is also the more fundamental question of whether renewables will, over time, eliminate the need for oil. That too, could weigh on the oil price, though it appears even on optimistic assumptions that transitioning to renewables will get time given the massive investments involved. Vaclav Smil has published many books relating to energy transactions and his conclusion is that energy use shifts can take decades because of the infrastructure required and, even then, old forms of energy don’t typically disappear. Remember energy companies may currently represent good value to investors even if they just exist for the next decade.
Another value of having some energy exposure in your portfolio is that perhaps predictably, energy companies move more with the price of energy than with the swings of the overall stock market. This isn’t always a good thing, if energy is down and the market is up, energy can be a drag on your portfolio. Yet, in the current market when many sectors are looking expensive, oil may offer the prospect of return and some diversification if the broader stock market should weaken and energy prices hold up better.
Energy Or Energy Stocks?
There are two main ways to include energy in your portfolio. One is to seek to own barrels of oil directly, another is to own the companies that make it. Generally, in the current environment owning the companies seems the better bet. Owning oil or gas appears the better course, this is because to make money owning a barrel of oil, basically you need the price of oil to rise. That may not happen and even if it did, history suggests things will turn around at some point. Plus owning oil is quite a complex, you need to manage the process and store the oil or place a set of financial trades to gain exposure that frequently need updating, those costs can eat into your return and often mean that funds aiming to track oil don’t follow it as directly as you might expect. On the other hand, most oil companies, don’t need the oil price to rise, most well established operators can make money at current levels even if the oil price does nothing. Also, the costs to owning them are generally lower. So oil companies will still do well if the price rises, just as direct commodity exposure would, but can also be a sensible bet if energy prices are simply flat.
What To Own?
Generally, a straightforward way to get exposure to any sector of the stock market is via ETFs. For example, the Fidelity MSCI Energy Index costs 0.084% a year currently, or a $0.84 per year for every $1,000 you invest. It owns approximately 140 companies, primarily U.S. based firms, such as Exxon and Chevron, plus some of the companies that service these firms such as Halliburton and Schlumberger. Vanguard also have a similar fund with a 0.10% expense ratio. Another option is the Energy Select Sector SPDR fund holds approximately 30 firms in a similar manner and the expense ratio is 0.13%, so a little higher. Generally, owning the fund with the lowest expense ratio can make the most sense, but if the Vanguard or SPDR ETF are offered commission free and the others are not, it may make sense to go with a commission free option. The lower number of holdings in the SPDR option is a slight concern, but actually whichever option you chose Exxon and Chevron will make up around a third of the portfolio given their large sizes.
All these options are U.S. only, and international diversification can be helpful, here the iShares Global Energy ETF is a reasonable option offering primarily additional European and Canadian oil stock exposure, however, the expense ratio here comes in quite a bit higher at 0.46%, that’s still not overwhelming, but may be a drag on returns over time compared to the U.S. options, especially since over half the funds exposure is U.S. based.
How Much Exposure?
At the moment, energy marks up about 6% of the S&P 500. So if you want greater exposure to energy, owning more than 6% in your portfolio would be a start, and generally moves of +/-5% in allocation start to have a noticeable impact on returns. However, overweighting any sector too heavily can harm diversification, so making energy more than 20% of your portfolio should only be done if you have high conviction and are willing to live with the ups and downs along the way, since a sharp fall in the oil price would clearly hurt your performance. Nonetheless, given the various reasons energy companies may be inexpensive, and the fact that energy is less correlated to the broader market than many sectors, may make now a reasonable time to seek additional exposure to energy within the stock portion of your portfolio if you’re comfortably with a slightly more active investing approach.