This article was written by Invesco PowerShares Senior Equity Product Strategist Nick Kalivas.
The recent plunge in oil prices has created a dramatic re-pricing of stocks in the energy sector. For investors who are looking for inexpensively valued stocks that may be poised to benefit from mean reversion (the theory that stocks move toward their average price over time), energy stocks are now on the radar for a rebound in 2015.
Let’s take a look at historically large declines in the oil market and valuations in the energy sector to get some perspective.
Examining historical price declines
The energy sector is likely to find the most buying interest when the crude oil market is near a bottom, but picking a bottom in any market is never easy and may be a fool’s game. Over the past 10 years, the price of the S&P 500 Energy Sector has a 0.829 correlation to the price of West Texas Intermediate (WTI) crude oil.1 Since the mid 1980s, there have been five times where the price of WTI has posted a decline of at least 40% from closing month high to closing month low. The table below compares those five historical periods with 2014’s price drop. (At the time of this writing, there were a few days left in December, so I used the Dec. 23 closing price of $56.52 to represent the month-end price.)
Major Oil Market Declines Based on Monthly Closing Prices of WTI
- The table indicates that the average and median durations for price declines are 10.3 and 8.0 months. If December 2014 were to mark a current low, the duration of the sell-off would be on the shorter side of history, at just six months. It seems like a bottom may be more likely in January or February 2015.
- The table highlights that the current decline of 46.4% (using the Dec. 23 close of $56.52) would be on the lower end of the distribution. The average and median declines are 55.2% and 54.1% respectively. The period most like the present (1985/1986, when the market was last awash in excess oil supply) saw a drop of 63.3%. The decline in 2008/2009 seems to be extreme as it was driven by a global economic and financial meltdown.
- Extrapolating based on historical examples is not without risk, but points 1 and 2 suggest that in 2015, we could see a close in the price of WTI in the $45 to $50 area in January or February, which could represent the bottom of the oil price plunge and lead to a cyclical recovery in energy shares.
Examining energy sector valuations
One way to examine the value of the energy sector is through the price-to-book-value ratio (P/B), which is affected not only by changes in companies’ stock price, but also by changes in the value of companies’ assets (book value). Monitoring this ratio over time helps to adjust for the impact of industry ups and downs. Oil properties and reserves are subject to impairment charges and changing values based on industry conditions —nonetheless, at some point the potential negatives are reflected in share prices. The P/B per share can shed light on when extremes are priced. Both the S&P 500 and the S&P SmallCap 600 Energy sectors appear to be approaching areas of perceived value based on their P/B ratios.
At writing, the P/B of the S&P 500 Energy Sector was 1.78 and on the lower end of the range seen since 1990. The ratio had lifted from a low of 1.605 on Dec. 15, 2014. These P/B ratios compare to an average of 2.39 going back to 1990. 1 (The black dotted lines represent two standard deviations above and below the average price, which would be considered extreme pricing levels.)
Valuation appears even more depressed looking at the S&P SmallCap 600 Energy sector where the price to book value ratio was 0.923. The ratio has lifted from a recent low of 0.78 on Dec. 15, 2014 and compares to an average of 2.02 going back to 1995. 1
Evaluating energy stocks
There are many factors that influence the outlook of energy stocks, but valuation and the price of oil are two places to start. Oil prices had a material decline in 2014, although it is too early to say they have bottomed and history may argue for more weakness into the New Year. At the same time, energy stocks are showing inexpensive valuation based on their P/B ratio, and valuation suggests investors may want to put the energy sector on their shopping list for 2015.
Investors seeking exposure to the energy sector may want to consider the PowerShares Dynamic Energy Exploration & Production Portfolio (PXE) or the PowerShares DWA Energy Momentum Portfolio (PXI).* PXE tracks an index that invests in exploration and production companies based on price momentum, earnings momentum, quality, management action, and value. PXI holds stocks that are displaying relative price strength. They are two smart beta solutions for investors looking for non-market-cap-weighted investment in the oil sector. Investors focused exclusively on the small-cap sector may want to consider the PowerShares S&P SmallCap Energy Portfolio (PSCE).
1 Source: Bloomberg LP as of Dec. 23, 2014
*Effective Feb. 19, 2014, changes to the fund’s name, investment objective, investment policy, investment strategies, index and index provider were made. Dorsey Wright & Associates, LLC replaced NYSE Arca, Inc. as the index provider for the fund, and the name of the index changed from Dynamic Energy Sector IntellidexSM Index to DWA Energy Technical Leaders Index. In addition, the name of the fund changed from PowerShares Dynamic Energy Sector Portfolio to PowerShares DWA Energy Momentum Portfolio.