The Energy Select Sector SPDR (NYSEArca:XLE), the largest exchange traded fund dedicated to energy equities, and rival energy ETFs are among the worst-performing sector funds this year. Worse yet, these funds and the energy sector in general have recently shown no signs of breaking out of what is now a lengthy slumber.
Adding to the bearish case for the energy sector is a multitude of headwinds facing the sector, several of which are directly attributable to the Organization of Petroleum Exporting Countries (OPEC) and its inability to support prices with production cuts.
The challenge for energy equities is that some oil market observers see more declines coming for crude. Oil traders are concerned over how fast U.S. shale oil producers will increase production to capture the rising prices.
While OPEC is cutting back to alleviate price pressures, U.S. fracking companies could jump to capitalize on the windfall as crude oil prices jump back above $50 per barrel – according to some estimates, shale oil producers can get by with oil at just over $50 per barrel due to advancements in technology and drilling techniques that have helped cut down costs.
“Once the OPEC cuts are lifted, full OPEC production coupled with rapidly growing U.S. output is likely to outstrip near-term demand growth and could easily tip the industry back into oversupply in 2018. Therefore, we are not changing estimates after this first look at the new OPEC agreement. Our 2018 and midcycle forecasts for WTI are still $45/bbl and $55/bbl, respectively,” said Morningstar in a note out Thursday.
However, investors will not find attractive valuations on lagging energy stocks. At least not at the moment.
“At nearly 28 times forward earnings, the sector’s forward price-earnings ratio is significantly above the second most richly priced sector, consumer discretionary. Its trailing price-to-earnings ratio is 33 times, second only to real estate among the 11 sectors,” reports CNBC.
Related: The Struggle is Real for Energy ETFs
Valuation concerns for the energy sector come even as the sector is featured prominently in an array of value ETFs. However, the sector looks more like a value trap than a legitimate value play over the near-term.
“Energy sector valuations look fairly valued at current levels with an average price/fair value estimate of 0.96,” notes Morningstar. “The consensus outlook is that market fundamentals are now strong enough to remain healthy even after OPEC returns to higher production.”
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