Is Energy’s Pullback a Buy?

The energy sector is this year’s worst performer in the S&P 500, down 10.5% through the end of May. 

Part of the weakness is a reversion to mean: After all, the energy sector was 2022’s best performer, as seen by the Energy Select Sector SPDR Fund’s (XLE) 64.2% total return. Year to date, it’s down 9%. WTI crude oil futures prices are down about 11.5% and its value drives fund performance. 

Prices started out the year strong based on forecasts that China’s post-COVID reopening would increase demand, and rallied when the Organisation of Petroleum Exporting Countries announced production cuts in April.  

But Chinese energy demand hasn’t returned as expected, especially on the industrial side, said Peter McNally, global head of sector analysts at Third Bridge. Oil prices temporarily spiked lower in early May when Chinese Purchasing Managers Index data was lower than expected.  

In the near term, Chinese demand will likely drive oil prices, and a recession in the U.S. could weigh on values. Limiting losses is OPEC’s attempts to curb output. The mixed forces directing traditional energy could offer some tactical opportunities, depending on the investor’s outlook.  

McNally says energy companies’ balances sheets are healthy, as they are now better capital stewards. “They're less prone to lighting money on fire with big projects, so you've got kind of some protection on the downside,” he said. 

ETF Exposure 

Daniel Milan, managing partner at Cornerstone Financial Services, said investors who felt like they missed out during 2022’s rally can use market weakness to establish positions, but he warns not to expect a repeat of last year. 

“Can you do some short-term tactical trading over Q2 and Q3 and have a nice little gain and clip some dividends? Sure,” he noted. 

Milan uses the iShares U.S. Energy ETF (IYE), which charges an expense ratio of 0.39% and has a distribution yield of 3.8%. Its top three holdings are Exxon Mobil, Chevron and Conoco Phillips, which comprise about 47% of the ETF.  

“If you just want exposure to the big boys, that’s the one,” he added. 

Milan also uses the smart-beta-focused, equal-weighted First Trust Energy Alphadex (FXN). It has a yield of 3.8%. The fund leans more toward midcaps such as its top holdings of PDC Energy and Chesapeake Energy, and comes with an expense ratio of 0.61%.  

The long-term question for traditional energy investors is the renewable energy transition, and that makes it tricky for buy-and-hold investors. Energy companies are investing money into renewables and emerging but unproven-at-scale technology such as carbon capture. 

“The trillion-dollar question with these stocks for the long term is, how can they pull off the transition? The good news for everyone living on the planet is, the industry has got money, and they've shown more of a willingness to spend it,” McNally said. 

Traditional Opportunities

That still leaves the present. Brett Manning, senior market analyst at Briefing.com, agrees that the industry is transitioning to renewables, but says there are still short- to intermediate-term opportunities in traditional energy in case there are stumbles along the way to an all-electric future.  

He noted the lack of exploration in the past several years will eventually tighten supply, and if there is a sudden need for fuel, and renewables aren’t able to cover the gap, it could cause a surge in demand, which could benefit oil companies.  

However, rather than own a broad-based ETF such as XLE, which includes a variety of companies, he suggested a focused fund, noting that some subsectors such as oil services companies have a limited future in the transition.  

“To me, it’s about who owns the oil,” Manning explained, citing the SPDR S&P Oil & Gas Exploration & Production ETF (XOP) as an example of preferred fund. 

“You can own shares with the people who own the oil,” he added. 

XOP charges a 0.35% expense ratio and pays a 3.05% dividend. EQT and Range Resources are its top two holdings.