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Drilling for Value

The energy patch looks attractive from a relative valuation perspective. 

John Gabriel, 12/20/2013

It can be challenging to find attractive investment opportunities in a market that is at (or near) all-time highs. It has been an excellent year for equities, as the S&P 500 Index has soared more than 27% through mid-December. Now, with a price/fair value of 1.01, according to Morningstar equity analysts, the S&P 500 currently appears to be fairly valued.

Some sectors have fared better than others. Taking a step back to view the market through a sector lens reveals that the energy sector has trailed the broader market this year and is currently trading at a 6% discount to Morningstar's fair value estimate. Energy stocks also have the lowest price/earnings, price/sales, and price/cash flow ratios of any equity sector. Along with its attractive relative valuation, the sector is also in solid financial condition. In fact, the energy sector's debt as a percentage of total capital is the lowest of any sector. Yes, that even includes technology stocks.

So what gives? The energy sector here at home has been a bright spot. We are in the midst of what many have called a domestic energy renaissance. United States oil production is strong, led by significant supply growth in Texas and North Dakota. Production growth has been so impressive that Morningstar analysts have predicted that by the end of 2013 China will overtake the U.S. to become the world's largest importer of crude oil. But, if things look so rosy, why is the sector trading at a relative discount?

Energy markets are very much global in nature. The story is not complete until considerations are made for the supply-and-demand dynamics around the world. While the sector looks promising from a domestic perspective, the global picture cannot be ignored. Issues abroad are clouding the outlook for the sector.

On the supply side, this includes uncertainty in the Middle East. International sanctions have significantly curtailed production in Iran. And while Syria itself is not a major oil producer, its proximity in the region (to Iraq, Kuwait, and Saudi Arabia, in particular) is cause enough for concern. Any negative developments are likely to have an outsize impact on oil prices given the large amount of oil production involved.

The global oil demand outlook is more promising, according to OPEC's monthly oil market reports. U.S. oil demand remains essentially unchanged from 2012 levels. But European oil demand is expected to fall in 2013 and 2014 as a result of a sluggish economy. Demand from China remains healthy for now, but could be a wild card for the sector given China's growing importance as a global oil importer along with the uncertainty that surrounds the country's economic outlook.

Exploring the Options
In lieu of attempting to pick individual winners, an exchange-traded fund offering low-cost diversified exposure could be the way to go for those looking to take advantage of the uncertainty plaguing the sector and capitalize on its attractive relative valuation. Energy Select Sector SPDR XLE can be used by investors as a tactical satellite holding to achieve broad exposure to the energy sector. At roughly one third of total assets, integrated oil and gas firms make up the largest weighting in the fund, followed by exploration and production firms (31%), equipment and services companies (17%), refiners (8%), pipelines (5%), and drillers (4%). The fund represents an inexpensive and efficient way to invest in the U.S. energy sector without assuming too much idiosyncratic (or firm-specific) risk.

As a market-cap-weighted fund, this ETF's portfolio is fairly top-heavy. Vertically integrated supermajors Exxon Mobil XOM and Chevron CVX alone make up more than 30% of XLE's portfolio. While these two firms represent a large chunk of assets, they operate in a diverse set of businesses across the energy complex. Their operations range from exploration and production all the way down to distribution. This helps damp the supermajors' volatility and sensitivity to energy prices but does not eliminate it entirely. Keep in mind that as a U.S. sector fund, XLE does not offer exposure to international supermajors such as P PLC BP,  Royal Dutch Shell RDS.A, or Total SA TOT.

John Gabriel is an ETF strategist with Morningstar and contributor to Morningstar ETFInvestor. Click here for a free issue.

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