Drilling for Value

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 BP PLC (BP), Royal Dutch Shell (RDS.A), or Total SA (TOT).

Other segments of the oil patch, such as exploration and production, are much more sensitive to volatile energy prices. Investors should expect the underlying firms' reliance on energy prices to translate into higher volatility for XLE relative to the broader market. For example, the S&P 500 experienced a standard deviation of returns of 15% over the trailing 10 years. Over the same period, the standard deviation of returns for XLE was about 23%.

Over the years, the diversification potential of XLE seems to have been eroding. Over the trailing 10-year period, it has been 70% correlated with the S&P 500. However, over the trailing five- and three-year periods, XLE's correlation to the S&P 500 has increased to 84% and 88%, respectively. Still, the fund remains an effective tool for investors seeking to overweight the energy sector within a broadly diversified portfolio. The energy sector currently makes up about 10% of the S&P 500 Index.

Digging Into the Fundamentals
Integrated oil and gas companies have operations that span the full energy value chain. These companies, which represent about a third of XLE's assets, explore for and produce oil and gas, transport it, refine or process it, and sell it to end users. The integrated model has historically provided firms like Exxon Mobil and Chevron with competitive advantages. By integrating across the energy value chain, these firms are able to gain much tighter control over the production and sale of oil and gas, and they get to keep profits they would otherwise have paid out to middlemen in the form of economic rents.

In an attempt to secure long-term access to large-scale resources, the large integrated firms are now competing for huge new projects and increasingly partnering with foreign national oil companies seeking to exploit government-owned resources. In a world of diminishing investable resources, securing such partnerships is important to help drive growth. This puts added emphasis on firms' technical expertise, ability to execute on time and on budget, safety records, and cost of capital.

Exploration and production companies, which make up roughly 31% of XLE's portfolio, concentrate their efforts almost exclusively on exploring for, acquiring, and producing oil and natural gas. These firms face myriad risks, including commodity price volatility, exploration risks, operational risks, and political and regulatory scrutiny. Given the intense competition in this segment as well as the difficulty individual firms face in establishing competitive advantages, getting diversified exposure through an ETF like XLE may be appropriate for most investors.

Equipment and services firms, which represent approximately 17% of XLE's assets, provide the expertise necessary to improve oil and gas well economics and boost well productivity. The industry does serve U.S. independent oil and gas firms, but its largest customers tend to be the major international and government-owned oil companies. Demand for services in any given year tends to wax and wane, depending on customer expectations around commodity prices, particularly in North America, where contracts are usually very short.

The cyclical nature of the industry can obscure some of the positive long-term trends, which look very favorable. Oil, in particular, is becoming harder to find and extract. Global oil production has been stagnant since 2005, even after a trillion-dollar investment by the oil and gas industry. The number of oil discoveries as well as the size of discoveries made has been declining for decades. Oil-services firms' expertise is growing increasingly more valuable as the industry seeks to explore and extract oil from ever-more-challenging frontiers in new deep-water and even Arctic efforts. Large efforts are also under way to boost recovery rates from old fields.

Portfolio Construction
XLE holds 44 oil and gas and energy-services companies included in the S&P 500 Index. These firms make up the energy sector's entire 10% 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 firm in the world, makes up roughly 17% of assets, and the top 10 holdings soak up approximately 60%. 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, Total, and BP. 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 $62 billion.

Select Sector SPDR ETFs are among the cheapest and most-liquid sector funds available. XLE's 0.18% expense ratio is low even by ETF standards.

Alternatives
The most appropriate alternatives to XLE are Vanguard Energy ETF (VDE), Fidelity MSCI Energy Index (FENY), and iShares Global Energy (IXC). Vanguard Energy, which is slightly cheaper with an expense ratio of just 0.14%, also provides a bit more diversification--it holds more than 160 names--but it is just as top-heavy as the SPDR fund. Similar to XLE, about 60% of VDE's assets are invested in the top 10 holdings. Despite VDE's additional holdings, the historical volatility of its portfolio has been nearly identical to that of XLE. Fidelity's FENY, which is the cheapest of the group with an expense ratio of 0.12%, is nearly identical to Vanguard's VDE in terms of its number of holdings and concentration. As a newcomer, FENY still has a small asset base and a fraction of the trading volume. Therefore, investors should take care when transacting in the fund's shares--watch out for wide bid-ask spreads and use limit orders.

IXC provides exposure to the international energy space, but that only serves to increase the fund's already substantial large-cap bias. Oil is a fungible commodity, so global prices tend to be highly correlated. We view international diversification within the energy space to be less beneficial than in other sectors of the market. In fact, XLE and VDE have been 98% correlated with IXC over the past five years. Moreover, the volatility of IXC fund is right in line with that of XLE. Given that the iShares fund charges 0.48%, which is more than twice that of the SPDR, Vanguard, and Fidelity funds, we would prefer sticking with one of the cheaper domestic funds under most scenarios.

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Disclosure: Morningstar, Inc.’s Investment Management division 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. John Gabriel does not own shares in any of the securities mentioned above.