We have long held the view that the Energy sector would underperform due to lower energy prices resulting from increased domestic shale oil production. Now that it has become the consensus view, we have to ask ourselves how much longer we want to stay with our almost zero allocation to the sector. A cornerstone of our call on Energy was the belief that the seemingly cheap equities of the oil majors were a value trap similar to banks and mortgage lenders in the year just prior to the financial crisis. Since then we have seen a massive increase in P/E ratios (now at 25.3) as earnings have slumped in recent quarters and unless energy prices, led by oil, rally significantly from current (WTI at $35) levels, earnings will not recover quickly.
Many investors appear to view the pullback in the Energy sector as a buying opportunity, but we are not so sure. Beyond the shorter-term issues of oil demand versus supply, there are secular threats to oil’s historic hegemony. Alternative energy sources as well as cheap natural gas are now challenging the business model of integrated oils such as Exxon and Chevron. Related to this, there is also a fierce debate about the future of fossil fuels and the need to properly price the externalities caused by their use. This is likely to lead to some form of Carbon pricing scheme with real impact.
In addition to the financial risks to Integrated Oil companies from Carbon pricing, many institutional investors are under pressure to divest their holdings. Companies that appear disinterested in finding sustainable solutions are perhaps most vulnerable as they come to resemble dinosaurs unable to adapt to changing circumstances. This is a potentially serious issue that has received relatively little attention in the US.
The three pillars of our underweighting of Energy are:
- When we decided to take a significant underweight position, Energy was, by a wide margin, the best performing S&P 500 Index sector over 10 years. History shows that sector performance exhibits strong mean-reversion over time, so unless new secular drivers have appeared, this alone would be a reason to expect energy to underperform the market going forward. The chart below shows the relative performance of XLE, the ETF that tracks the Energy sector in the S&P 500 Index, and SPY, the broad S&P 500 Index ETF. As we can see, the Energy sector had massive outperformance versus the broader market until 2014, when the drop in Oil prices put a sudden end to the fun.
- As medium to long term sector investors, we seek more exposure to sectors that are increasing their share of GDP over time and less to those that decrease in share. Energy is perhaps the clearest case of a sector in long-term decline as a percentage of GDP. As the economy becomes more efficient, each unit of GDP has a lower Energy component. In the 1940’s Energy was roughly 17% of GDP, now it is about 7%.
- Energy prices have been falling since the “Shale Revolution” resulted in increased US oil and gas production, starting with natural gas dropping by 85% since 2008. This was then followed by a similar price drop in coal, which competes directly with gas in power generation. Recently, we have seen a significant drop in oil driven by the same supply dynamic. However, even with oil at $35 the price on an energy-equivalent basis is still almost three times higher than natural gas.
The fall in oil prices has served as the catalyst for a major correction in the Energy sector versus the rest of the market, and just as Financials have taken a very long time to recover from the 2008-9 slump, we believe the Energy sector will continue to lag the overall market.