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A Low-Cost Way to Make a Diversified Bet on Energy Stocks

Energy Select Sector SPDR ETF bundles energy stocks from the S&P 500 for a low fee.

Ben Johnson, 02/17/2017

Energy Select Sector SPDR ETF XLE offers broad, inexpensive exposure to the energy sector. This exchange-traded fund invests in every energy company in the S&P 500 and weights its holdings by market capitalization. This includes integrated oil and gas producers, firms that engage in oil and gas exploration and production, companies providing oil and gas equipment and services, and those in the refining and marketing segment of the value chain. From a commodity-type standpoint, firms related in some manner to oil and gas comprise more than 80% of the assets of this ETF, with equipment and services firms making up the balance. Because of this ETF's industry concentration, this fund would be most suitable as a satellite holding in a diversified portfolio.

This portfolio is top-heavy. It is dominated by a pair of heavyweights: vertically integrated supermajors Exxon Mobil XOM and Chevron CVX, which together make up more than 30% of XLE's assets. While these two firms represent a large chunk of assets, they operate in a diverse set of businesses across the energy complex. Energy-market volatility has had a major impact on United States equity-market performance in recent years. That has made this fund far more volatile than the broader market. For example, over the past 10 years, this ETF's standard deviation of returns of 22.2% is far higher than the 15.3% posted by the S&P 500. And XLE's three-year standard deviation of returns of 19.2% also far eclipses the 10.5% logged by the broad benchmark. Within this fund, some of the greatest volatility can be found in the performance of energy exploration and production firms such as Schlumberger SLBBaker Hughes BHI, and Halliburton HAL. In aggregate, exploration and production firms make up just under one fifth of this ETF's assets.

Fundamental View
Energy-price volatility has become the new norm. After years of stagnant oil production, oil supply has risen dramatically, as U.S. producers have continued to bring new supply online, particularly in the Bakken and Eagle Ford Formations, owing largely to new drilling methods, such as hydraulically fractured, tight oil wells. In early 2017, U.S. oil producers were bringing record amounts of crude to the global market, while members of OPEC were curtailing production in an attempt to support prices. U.S. natural gas prices also have been held low amid abundant supply. This combination of oversupplied oil and gas markets has meant considerable recent pain for the firms found in this ETF, particularly those in the exploration and production space.

There appears to be no such thing as a "steady state" when it comes to commodity prices, and investors shouldn't expect oil and gas markets to remain oversupplied forever. While predicting very short-term commodity-price movements is extremely difficult, Morningstar's equity analysts see no immediate relief to this period of oversupply. However, for investors taking a medium- or long-term view, there are several potential signs of hope for the energy sector.

First, ailing energy producers in the U.S. have reduced their upstream capital spending. Lower investment should mean less output, which over time could contribute to a rebalancing of the markets. In addition, less oil-directed drilling activity theoretically could mean lower growth in U.S. lower natural gas production. And while it is far more difficult to place a probability on such events, a far more immediate impact on energy prices could come from some geopolitical event involving a major oil-producing nation.

Given that Exxon Mobil makes up such a large portion of this ETF, it is worth discussing its outlook. Exxon has distinct and sustainable competitive advantages, as evidenced by the fact that Morningstar Research Services LLC awards Exxon a narrow Morningstar Economic Moat Rating. Exxon’s moat comes from its integration of its low-cost upstream and downstream businesses and its low cost of capital. (By contrast, refining operations generally offer no moat, because refiners produce a commodity product in a highly competitive market with no pricing power.) While Exxon responded to the slowdown in energy prices by reducing capital spending, it may need to increase spending within several years to maintain production. In addition, should oil prices remain low for an extended period of time, Exxon may well need to increase debt to avoid reducing share repurchases and slowing dividend growth.

Portfolio Construction
This ETF holds the 36 oil and gas and energy-services companies found in the S&P 500. These firms make up the energy sector's entire 7.0% weighting in the S&P 500. The weightings of each stock roughly correspond to each stock's market cap. Thus, Exxon Mobil, the largest oil company in the world, makes up about 16% of assets, and the top 10 holdings soak up more than 64% of assets. Constituents are leading U.S. companies that meet S&P's profitability criteria. These criteria eliminate non-U.S. oil companies, including Royal Dutch Shell RDSATotal TOT, and BP BP. Mega- and large-cap stocks make up about 85% of the portfolio, with mid-caps representing the remaining 15% of assets. The holdings-weighted average market capitalization of the fund's portfolio is about $60 billion.

Fees
Sector SPDR ETFs are among the cheapest and most-liquid sector funds available. The fund's 0.14% expense ratio is low even by ETF standards.

Alternatives
Vanguard Energy ETF VDE owns a broader range of energy stocks and comes with a lower price tag. The fund's fee amounts to 0.10%, and as of Dec. 31, 2016, it held 133 stocks.

The pricier iShares U.S. Energy IYE (0.44% expense ratio) holds 71 firms and is very similar to XLE in its concentration and security weightings.

Fidelity MSCI Energy ETF FENY is the least expensive of the bunch, with a 0.08% fee. FENY tracks a slightly different index from VDE--the MSCI USA IMI Energy Index. VDE is tied to the MSCI US Investable Market Energy 25/50 Index. The two benchmarks are very similar, with nearly identical weighting schemes and minimal differences in holdings.

For international energy exposure, investors can consider iShares Global Energy IXC, which charges 0.47%. IXC's global focus does not meaningfully improve its diversification relative to its U.S.-focused counterparts. In fact, IXC has an even more pronounced large-cap bias.

 

Disclosure: Morningstar, Inc. licenses indexes to financial institutions as the tracking indexes for investable products, such as exchange-traded funds, sponsored by the financial institution. The license fee for such use is paid by the sponsoring financial institution based mainly on the total assets of the investable product. Please click here for a list of investable products that track or have tracked a Morningstar index. Neither Morningstar, Inc. nor its investment management division markets, sells, or makes any representations regarding the advisability of investing in any investable product that tracks a Morningstar index.

 

Ben Johnson is Morningstar’s Director of European ETF Research.

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