Market Overview

Energy Stocks Look Cheap, Are These ETFs Buys?


In a classic economic conundrum, energy stocks have been battered this year due to rising oil supplies and slack demand. Year-to-date, the Energy Select SPDR (NYSE: XLE) is down approximately 4.3 percent compared to a gain of around 8.4 percent for the SPDR S&P 500 (NYSE: SPY).

This SPY gain occurred despite downward pressure from energy stocks. More specifically, energy stocks comprise around 11 percent of the S&P 500. Energy equities are also prominent on the international stage, comprising roughly 10 percent of all global equities, according to Bloomberg.

Considering those statistics, broader market upside may be limited until the energy sector starts to pull its weight. On the other hand, if oil and natural gas equities start contributing positively, the ensuing rally could be impressive.

Bloomberg found that there have been two occasions since 2000 when the energy group lagged the S&P 500 for four months or more. On both occasions, the broader market index fell over the next three months with losses averaging 12 percent, Bloomberg reported.

However, energy stocks may now look cheap relative to the S&P 500. So, investors might be able to scoop up shares of energy companies at attractive prices. As the Bloomberg piece notes "The plunge in shares of fuel producers has reduced valuations to 9.50 times 12-month earnings, Bloomberg data show. That's 28 percent below the S&P 500's multiple of 13.3 and the widest discount since September 2009."

If investors believe energy stocks are undervalued, the following ETFs could benefit from bargain hunting within the sector.

Energy Select Sector SPDR (NYSE: XLE): This fund is the largest ETF tracking the energy sector. As of June 29, XLE was sporting a price-to-earnings (P/E) ratio of 10.87 compared to 13.07 for SPY. XLE's price/book ratio of 1.7 is also lower than the 2.12 sported by SPY.

XLE is home to 46 stocks, but investors might pay special attention to the performance of just two of those names. Exxon Mobil (NYSE: XOM) and Chevron (NYSE: CVX), the two largest U.S. oil companies, account for close to 36 percent of XLE's weight. As such, that pair often sets the table for XLE in terms of performance.

In this ETF's bull case scenario, value fund managers would start to consider Exxon and Chevron as cheap and add to existing positions or initiate new trades in those stocks. The bear case for XLE is that Exxon, Chevron and friends keep getting cheaper as oil prices falter.

First Trust ISE-Revere Natural Gas Index Fund (NYSE: FCG): The First Trust ISE-Revere Natural Gas Index Fund, when compared to the broader market, is not as cheap as XLE. Nevertheless, FCG, which had a P/E ratio of just over 12, has surged 11.6 percent in the past month as traders have bid up natural gas futures.

With natural gas demand rising and production expected to decline, FCG may be positioned to take advantage of those trends. Many of FCG's 31 constituents are also actively engaged oil production, but the market largely views this ETF as a natural gas play. For once, that may be a good thing. FCG would confirm a breakout on a move above $17.

SPDR S&P Oil & Gas Exploration & Production ETF (NYSE: XOP): XOP's P/E ratio of around 12.23 is higher than XLE's, but the former's price/book is lower. So, XOP may offer decent value here. The more volatile XOP has performed in line with XLE on a year-to-date basis, but has outperformed its more conservative rival in the past month.

XOP's beta of 1.66 relative to the S&P 500 is far higher than XLE's of 1.24. XOP's annualized volatility is more than 600 basis points higher than XLE's, according to SPDRs data.

In other words, XOP's valuation may be tempting, but investors must note that this ETF is not filled with relatively conservative energy names, such as Exxon and Chevron. With a higher beta constituency, XOP can be more vulnerable to the gyrations of energy futures. The potential upside to the fund's current composition is its gassier feel, implying that XOP could rally if natural gas prices continue their upward trajectory.

For more on energy ETFs, click here.


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