MorningWord 10/28/14: From Hero To Goat – $XLE

by Enis October 28, 2014 9:52 am • Commentary

The relative underperformance of the energy sector vs the rest of the market since July has been quite a sight. A simple chart of sector ETF performance in 2014 does the trick (XLE in white):

Sector ETFs year-to-date percentage performance (legend top left), courtesy of Bloomberg
Sector ETFs year-to-date percentage performance (legend top left), courtesy of Bloomberg

XLE’s collapse has been highly correlated to crude oil, which continues to meander near 3 year lows this week:

Front month crude oil, courtesy of Bloomberg
Front month WTI crude oil contract weekly chart, courtesy of Bloomberg

The fundamental situation in the sector has changed drastically simply because of the commodity price.  At the end of this week, we get the first earnings reports from the 3 behemoth energy companies, XOM, CVX, and COP, results that ecompass a period where all 3 went from 52 week highs to 52 week lows.   Those 3 stocks comprise about 35% of the XLE ETF, so their reaction to earnings (COP on Thursday morning, XOM and CVX on Friday morning) could be a market mover and a good barometer for the nature of positioning in the energy sector after the selloff.

Looking at the history of EPS and the P/E multiple for all 3 majors over the past 5 years, the valuation multiple has actually been relatively stable for all 3 stocks.  It has fluctuated between 8 and 14 for all 3 of them:

Trailing 12 month P/E ratios, courtesy of Bloomberg
Trailing 12 month P/E ratios, courtesy of Bloomberg

Assuming that valuation history holds, the main remaining variable then is the EPS result over the next year. Analysts have rapidly reduced estimates in the past month as the oil price outlook has moved lower.  The especially steep decline has made the forecasting process especially difficult for analysts who already tend to lag changes in the underlying business in their projections.

However, complicating the picture for XOM, CVX, and COP has been their lackluster results over the past few years even during a period of high energy prices.  Here is the table of total sales and EPS for all 3 companies since 2009, illustrating the stagnating businesses:

Screen Shot 2014-10-28 at 9.33.37 AM

(COP spun off PSX in 2012, hence the big drop in revenues).

XOM, CVX, and COP have all seen declining sales in the past 3 years, and XOM and CVX have also seen their EPS decline.  Analysts are projecting a slight decline in EPS and sales for 2015 (0-10%) for all three companies.  Given this overall picture, if the oil price decline holds over the next 6-12 months, the energy majors are going to be particularly hard pressed to achieve even those relatively low existing sales and EPS projections.

Add to that the risk of continued multiple contraction if the energy sector’s investment environment remains weak, and it’s hard to make a strong fundamental case for owning the energy majors.  The probability of a surprise for the group on a fundamental basis seems skewed to the downside.  That doesn’t mean there is a trade here given their already oversold positions technically, but we’ll continue to follow this theme closely in the coming months.