Is It Time to Overweight the Energy Sector?
In a word. Yes.
It is no secret that the energy sector has been taking off during late 2017 and now, into early 2018. Can it continue? Is the rally overdone? We think it can continue.
The anticipation and realization of tax reform has given the energy industry a significant boost. There are other factors that can continue to propel the energy sector forward.
Clearly, oil prices influence the profitability of oil and gas companies. As oil prices have risen, however, the price of oil and gas stocks has not kept pace. Perhaps the reason is skepticism over prices remaining high. OPEC and demand have a lot to do with oil prices. We do not pretend to have a crystal ball into what OPEC may or may not do. What we do know is this: economic activity worldwide has been picking up. Many economies are revving hotter. Moody’s recently forecasted from 5-12% EBITDA increase in various oil and gas industries in 2018, and this was before tax reform. Thus, there is increasing demand for oil and a probable return to a measure of financial health.
Some feel that as prices rise, U.S. shale production will increase in tandem, which will keep prices low. Well, so far, that has not driven prices lower. It will likely keep oil prices within a range. Remember, however, that oil and gas companies have had to scale back greatly on their operational expenses just to survive the downturn in oil prices over the last few years. For many of them their break even price is $30, $40, and $50 per barrel. This means they can operate profitably in a $60+ per barrel environment. That is where we are at.
Oil and gas companies are some of the highest taxed companies. They should benefit from both lower tax rates and the ability to immediately deduct capital expenditures, which will also reduce taxes. Some analysts are predicting earnings increases in 2018 for a number of energy companies from single digits up to 614%. These projections might not come true completely, but it shows there is likely upside for many companies in the industry. This is what will drive the sector to outperformance.
In our valuation work, we are seeing higher fair value estimates for multiple companies when we factor in even low levels of EBIT profit and lower tax rates. This is a conservative estimate and even so, results in higher valuations. We think the market has not yet adjusted to these or higher levels.
The Technical Picture
Simply looking at XLE we see prices moving higher towards $82.80 in the near-term but perhaps as high as $89 in the months ahead.
We are also looking at some individual energy companies which have a very compelling valuation and technical backdrop. Aspen clients will be updated as those trades begin to develop.
As we mentioned in our recent piece on Real Estate, the poorest performing sector from last year can at times become the best performer in the current year. Energy was the biggest loser last year and this year, we believe it will perform much better. We are overweight energy in our S&P 500 benchmarked model portfolio.