Taking a fresh look at XLE
Bull thesis broken, sentiment in ashes and positioning lopsided. Is that a cocktail for a decent contrarian call? Might this be the purest 'no landing' asset of all?
Disclaimer: The information contained in this article is not and should not be construed as investment advice. This is my investing journey and I simply share what I do and why I do that for educational and entertainment purposes.
The Energy Select Sector SPDR Fund XLE 0.00%↑ is comprised of 23 US companies engaged in oil, gas, consumable fuels, energy equipment and services. I covered this ETF in December 2022 when I argued that the long energy trade was overextended and destined to underperform.
It aged very well in relative terms. Since I published my report, XLE has been flat while the S&P advanced by more than 20%. This substantial underperformance has driven a lot of investor frustration. People abandoned energy stocks in droves. Identifying the reasons is easy. First the bull case did not materialize. And then the hard and soft landing narratives made investors chase other assets.
I believe it is now a good time to revisit this sector, this time with a different hypothesis: Is it a decent vehicle to get exposure to no landing value stocks that I recently set out to search for?
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Bulls are completely disheartened by a seemingly broken bull thesis. The commodity inflation thesis was based on a 1970s style entrenched inflation scenario, which has not (yet) materialized. The underinvestment supply shortage thesis is so far also not materializing. Global excess production capacity is in fact higher than before the pandemic. Sanctions, most importantly on Russia, have not put a dent into supply as hydrocarbons find other ways to consumers in a globally interlinked economy. And lastly, Joe Biden is not making any attempts for a forceful refill of the SPR. Why would he? The US have become a net exporter of primary energy. That renders the SPR obsolete. At least in its historical size. And outside of the SPR, inventory levels are just fine.
All of this has utterly destroyed sentiment. Positioning data in investor surveys and derivatives positioning suggests that investors have completely neglected this sector. Energy is now the most hated sector per the Bank of America Fund Manager Survey (FMS). Many are apparently actively betting against it. Derivatives positioning is at its shortest level in decades. In 4Q23 alone, traders shorted the equivalent of 120m barrels, the equivalent of 7% of total US consumption during the same period. Presumably, this is a manifestation of the whole soft/hard landing consensus that makes everyone chase long duration assets.
But there is hope beyond merely fading the crowd. In spite of the excitement about renewable energy, rumors of the death of oil as a crucial economic commodity have been greatly exaggerated. As I will show below, economic growth is still highly correlated with its consumption, making it a suitable vehicle to bet on an economic upside surprise. Economic growth expectations baked into oil demand projections are unambitious. It won’t take much to exceed them, especially since some particularly energy intensive industries such as road and airline traffic are still below their prepandemic trajectories.
It appears that the upside in such a bet exceeds the downside significantly. US energy companies are very strong financially. They have deleveraged hard and their valuations are very unambitious. Net debt/EBITDA has fallen from 3x in 2017 to just 0.7x today, the lowest level since 2012, before the fracking bonanza began.
Lastly, we have a few tail risks to deal with this year, most importantly the US presidential election and quite a few geopolitical hotspots around the world. Exposure to US energy stocks seems suitable as a hedge to some of the tail risks associated with these issues.
Let’s go through all of this in detail.