Why Energy Is Worst Sector Of 2017

Talk about a change of fortune. After being the top-performing sector last year, energy is the worst-performing sector so far in 2017―and it isn't even close.

The $15.7 billion Energy Select Sector SPDR Fund (XLE), the largest ETF tracking the sector, is down 14% year-to-date.

That's double the loss of the next-worst-performing sector―telecom―and well behind the more than 8% gain for the broader S&P 500 in the same period.

It's increasingly clear that the rebound in energy that many expected in 2017 is unlikely to come to fruition, for a number of reasons.

US Output At 2-Year High

The most obvious factor weighing on the energy sector is the surge in U.S. oil production. Since the start of 2017, crude oil production in the country climbed more than 6%, or 500,000 barrels, to 9.3 million barrels per day―a two-year high.

US Crude Oil Production

What those figures suggest is that not only can U.S. oil producers weather sub-$50 oil prices, they can thrive with them thanks to advances in technology and lower costs. The International Energy Agency (IEA) anticipates that production at the end of 2017 will be 920,000 barrels per day higher than at the end of 2016, and that it will grow another 780,000 barrels per day by the end of next year.

These are the types of growth rates witnessed when oil prices were above $100 a few years ago, and not something many would have anticipated in today's much lower oil price environment.

Of course, rapidly expanding output is great for U.S. oil producers at an individual company level. But when everyone is growing their production by leaps and bounds, it's naturally going to drag oil prices down, hurting the whole sector.

That's exactly what's happened as WTI crude oil futures sagged by 17.7% year-to-date and the front-month tracking United States Oil Fund (USO) dropped by 22.4%.

YTD Return For Spot Crude Oil, USO, XLE

The Libya & Nigeria Surprise

Making matters worse, the pressure on oil prices isn't just coming from U.S. energy companies. Seemingly out of nowhere, there's been a most unexpected resurgence in oil production for Libya and Nigeria. The two volatile African nations have seen their combined output jump nearly 1 million barrels per day from last year's lows, offsetting much of the production cuts from the rest of OPEC.

Indeed, given the recent woes afflicting the energy sector, it's easy to forget that a 1.7 million barrel per day production cut agreement between OPEC, Russia and other oil-producing nations is still in effect. That agreement, which became official at the start of 2017 and runs until March 2018, is perhaps the only thing keeping oil prices from further collapsing.

Currently, compliance with the production cuts is an impressive 93%, but if producers begin to question whether the pact is worth maintaining, that figure could drop fast, pushing prices down even more.

Bearish Analysts

Spooked by the wave of supply coming from multiple sources, many Wall Street analysts have grown bearish on the energy sector.

“It is now consensus that global oil markets will swing into surplus in 2018, and the burden of proof that this will not happen lies with the bulls," said Ole Slorer, U.S. oil services analyst at Morgan Stanley.

Mike Kelly, an analyst at Seaport Global, went even further, remarking that oil prices may revisit their lows from early 2016.

“Something has to give to keep the market in balance,” he said. "Per-barrel prices may fall back into the $20s early next year and average $35 a barrel in the first half of 2018, prompting massive cuts in U.S. drilling rigs."

Devil's Advocate

With these gloomy forecasts in mind, it's not hard to imagine why energy is performing so poorly this year and why it may continue to face head winds going forward. That said, there's always a more optimistic case to be made, if only for purposes of playing devil's advocate.

In that regard, one thing to consider is that the increase in oil production from Libya and Nigeria may not prove to be sustainable. As the IEA points out, given the nature of these two unstable countries, the recent increase in production there "could easily fall back."

Meanwhile, even the growth of U.S. oil production could face head winds if prices fall low enough. After all, the collapse of oil to $26 in 2016 did the trick of finally bringing U.S. output down, as short-lived as that proved to be.

The deciding factor in whether it's worth wading into energy from an investment perspective is not necessarily where oil prices are headed in the short term―that's impossible to predict―but where valuations stand relative to an investor's long-term oil price forecast.

After a 15% decline in XLE and even larger pullbacks in other energy funds—such as the 26% swoon in the SPDR S&P Oil & Gas Exploration & Production ETF (XOP)—to some investors, energy may be starting to look attractive compared to other sectors where valuations are more stretched.

For other investors, share prices may need to pull back even further before they reach bargain levels. In either case, energy has distinguished itself as the rare area where prices are getting cheaper in a stock market that has otherwise been on a one-way track higher.

Contact Sumit Roy at [email protected]