• Two years of problems for energy-related stocks

• The XLE continues to underperform crude oil and the stock market

• Deep value but a changing landscape for energy

• Five stocks to consider- Stick with the leaders

• Value is subjective, and a challenge to locate in the current environment- Risk-reward favors a rebound in energy for survivors

The stock market has stalled as market participants await the results of the US election on November 3. However, all of the leading indices are trading a stone’s throw away from record highs. After a severe correction in late February and March, stocks experienced a V-shaped recovery. The technology sector has done the best as the NASDAQ rallied to a series of new and higher highs.

Meanwhile, 2021 could present a set of challenges for technology stocks. The leading companies have grown to levels where they have dominant positions, and access to valuable data makes lawmakers in Washington DC more than a little nervous. The potential for breaking up some of the companies and introducing new regulations is rising. There is growing bipartisan support for addressing the financial and technological dominance of the tech sector leaders.

Meanwhile, those holding shares in energy companies have suffered over the past two years. While many leadings in the oil and gas sector continue to pay juicy dividends, their share prices have languished while other stocks have recovered, and many have moved to record highs.

Locating value in the stock market has been more than a challenge over the past months. In the energy sector, bargains are easy to find. The uncertainty of US energy policy in the aftermath of the election continues to weigh on the sector. Markets do not respond well to uncertainty. In the aftermath of the election, we could see a significant recovery in the leading energy-related companies as they offer substantial value at their current share prices. The Energy Select Sector SPDR Fund (XLE) holds shares of the top oil and gas companies.

Two years of problems for energy-related stocks

In May 2018, the Energy Select Sector SPDR Fund (XLE) reached a peak of $79.42 per share. Since then, the product that holds its assets in many of the leading energy companies in the US has made lower highs and lower lows. As of October 22, the XLE was around the $30 per share level.

Source: Barchart

The chart highlights that the XLE fell to a low of $22.88 in mid-March 2020 during the risk-off period in the stock market and when the price of crude oil was on its way to the lowest price since futures began trading on the NYMEX in April.

After bouncing to a high of $46.88 in early June, the selling resumed, taking the ETF to the $30 level in late October. The most recent top holdings and fund summary for XLE include:

Source: Yahoo Finance

The XLE has over 45% of its net assets in Exxon Mobile (XOM) and Chevron (CVX), the two leading US integrated oil companies. The ETF has net assets of $8.39 billion, trades an average of over 24.1 million shares each day, and charges a 0.13% expense ratio. The blended dividend yield was over the 13% level. Since May 2018, the energy-related shares have been the worst sector of the stock market.

The XLE continues to underperform crude oil and the stock market

From the 2018 high until October 22, 2020, the XLE declined from $79.42 to $30.07 or 62.1%.

Source: CQG

As the weekly chart illustrates, nearby NYMEX crude oil futures fell from a high of $72.83 in May 2018 to $40.58 as of October 22, a drop of 44.3%. The XLE underperformed the crude oil market over the period.

Source: Barchart

Meanwhile, the high in the S&P 500 index in May 2018 was 2,954.13. At 3,446.20, on October 22, the stock market index was 16.7% higher as the stock market left the energy sector in the dust.

Deep value but a changing landscape for energy

Beauty and value are in the eyes of the beholder. The performance of energy-related stocks has been ugly for almost two and one-half years. In August 2020, the Dow Jones Industrial Average removed Exxon Mobile from its ranks and replaced the oil company with Salesforce.com (CRM), a technology company. The move caused even more sales in XOM shares. The only oil company left in the index is Chevron (CVX).

The landscape for energy stocks has changed dramatically. The performance of companies that extract fossil fuels from the crust of the earth has been awful because of the growing trend towards alternative energy sources. While cleaner energy sources reflect the future, leading oil companies like XOM and CVX continue to provide crude oil and other energy products worldwide.

XOM reported a profit in three of the past four quarters, with the only loss coming in the second quarter of 2020 when the price of NYMEX crude oil futures fell below zero for the first time. XOM shares were trading around the $34 level on October 22. A survey of twenty-two analysts on Yahoo Finance has an average price target of $45.41 for the stock, with projections ranging from $30.50 to $77 per share. At the recent share price, XOM still had a dividend yield of over 10%.

At the $72 level, CVX reported profits and beat analyst estimates in three of the last four quarters. Like XOM, the company reported a loss in the challenging second quarter of this year. A survey of twenty-four analysts on Yahoo Finance has an average price target of $96.79 per share, with projections ranging from $69 to $121 per share. CVX was paying its shareholders an over 7% dividend.

XOM and CVX offer significant value compared to the overall stock market. However, the upcoming US election is, among many things, a referendum on the future of energy production and consumption in the world’s wealthiest nation.

The US became the world’s leading producer of crude oil and gas over the past years. Technological advances in fracking, which allowed producers to extract the hydrocarbons from the crust of the earth for costs that were below-market prices, lifted output. Simultaneously, fewer regulations under the Trump administration supported the energy industry. Decades of the quest for energy independence led the US to become a leading producer.

Meanwhile, a sweep by Democrats on November 3 could limit or even stop the flow of fossil fuels. Increased regulations and more environmentally friendly energy policies would likely decrease the flow of oil and gas. For the leading oil and gas companies, the share prices over the past years may already reflect the policy change if the opposition party wins the election.

Five stocks to consider- Stick with the leaders

When it comes to the energy sector, I would only consider the leading companies with reliable earnings records and relatively low debt levels. One of the most significant problems facing the energy sector over the past years has been that low-interest rates encouraged borrowing.

Rising debt levels became more than a challenge to service in 2020 with the price carnage during the first half of the year. We are likely to see a continuation of consolidation in the energy industry into 2021. Those companies with stronger balance sheets will have the opportunity to purchase inexpensive assets for pennies on the dollar. Another risk-off period could accelerate the process.

XOM and CVX are the top two US energy companies, and they are at the top of my list. I would not put all of my eggs in one basket when it comes to accumulating shares. I would hold a small core long position at current levels and add to it on price weakness. Even if the dividends were to disappear, Exxon and Chevron offer substantial value at their current share prices.

I favor accumulating energy companies that are strategically positioned within their countries. British Petroleum (BP), Royal Dutch Shell (RDS-B), and Total (TOT) round out my favorite list of oil stocks. These three energy companies are as close to state companies as it gets, and their survival is a matter of national security for Europe. I would only stick with the leaders. While other energy companies that produce oil and gas may look more attractive, the odds of survival for OM, CVX, BP, RDS-B, and TOT are high.

Value is subjective, and a challenge to locate in the current environment- Risk-reward favors a rebound in energy for survivors

It is more than a challenge to identify value in the stock market these days. Technology stocks have been all the rage in 2020. The global pandemic turbocharged the sector. We have seen companies like Zoom (ZM) and Tesla (TSLA) soar. While the trends in these companies and others that have experienced explosive share moves remain higher, the value proposition is suspect.

Moreover, the potential for increased regulation and breakups of technology companies could send investors and traders to other sectors to uncover value over the coming months. The leading energy companies stick out like a sore thumb when it comes to value. Meanwhile, companies’ managements realize that the landscape for energy is changing. All of the leaders are modifying their business plans to operate within a new normal where the carbon footprint must decline.

Risk-reward is a critical factor in investing and trading. After years of underperformance, the leading companies in the energy sector offer value, which could turn out to be a magnet in 2021. Any periods of price weakness during the coming months could create additional buying opportunities that will pay off in 2021.

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XOM shares were trading at $34.92 per share on Friday morning, up $0.06 (+0.17%). Year-to-date, XOM has declined -47.23%, versus a 8.81% rise in the benchmark S&P 500 index during the same period.

Andy spent nearly 35 years on Wall Street and is a sought-after commodity and futures trader, an options expert and analyst. In addition to working with StockNews, he is a top ranked author on Seeking Alpha. Learn more about Andy’s background, along with links to his most recent articles.

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