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Energy Sector Humming On Low Volatility

Paul Baiocchi


In 2012, all 10 GICS sectors finished in positive territory, but energy lagged.

So far in 2013, it has been the hottest sector. Is it time to jump back in?

2012 proved to be a very challenging year for energy firms. Although the sector, as measured by the Energy Select Sector SPDR Fund  (XLE), eked out a 2 percent  gain for the calendar year, it was the worst-performing sector in the S'P 500, lagging the best performer, the Financial Select Sector SPDR Fund (XLF), by 23 percentage points.

There were a number of contributing factors that caused XLE to lag, many of which have been covered in much better detail by the team over at HardAssetsInvestor.com .

The point is, 2012 was a trying year for energy investors, despite the advent of new easing policies from the Federal Reserve and promise of improving economic activity.

Fast-forward to January 2013:Although we’re just a month into the year, energy has reversed its fortunes and has provided the best year-to-date sector returns.

Before we try and determine if this latest rally has legs, it’s important to note that wild year-to-year performance swings in the energy sector are hardly a surprise.

Over the past 10 years, energy has been either the best- or worst-performing sector seven different times—more than any other sector by a wide margin. It should also come as no surprise when you consider that energy was the second-most-volatile sector (24 percent average annual volatility) behind financials over the past 10 years.

That’s perhaps more impressive when you account for the fact that energy did not have a “black swan” event like financials, where large chunks of the industry disappeared.



Even last year’s 2 percent return came with some vicious swings:XLE was up 7 percent as late as Feb. 24 last year, and ended up needing a year-end rally to erase what was at one point a decline of 12-plus percent. 

Now that we’ve established just how volatile energy has been over the past decade, we can go about determining if the recent rally has legs and, crucially, if there are any structural changes taking place in the market that may dampen that volatility moving forward.

The market certainly seems to be saying the answer to the first question is a resounding yes. Just take a look at some of the ETFs tracking subsectors of the energy market:Don’t look now, but the Market Vectors Oil Services ETF (OIH) just hit an 18-month high, while the iShares Dow Jones U.S. Oil ' Gas Exploration ' Production Index Fund (IEO) is trading at a level not seen since last March.

Meanwhile, the best ETF proxy for gasoline, the futures-based United States Gasoline Fund (UGA), is trading at a 52-week high.

The price action in UGA is especially noteworthy for XLE investors because XLE is dominated by the massive integrated oil firms like Exxon Mobil and Chevron.

The stronger the market for gasoline, the more revenue these firms earn and—all else being equal—the higher the multiple the market will be willing to place on them.

Of course, I would be remiss if I didn’t mention that U.S. oil production is at a 20-year high, while OPEC is cutting production.

To put that in context, year-over-year crude oil output in the U.S. rose by an average 1.3 million barrels a day, which represents a 22 percent increase. That is a massive jump in production that disproportionately benefits large oil-producing firms here in the United States that make up the heart of XLE’s portfolio.

In other words, the stage is set for domestic energy companies to have a fantastic year, if not a fantastic decade.

Meanwhile, volatility in the futures market, as measured by the CBOE’s Oil Volatility Index, just hit the lowest level since 2007.

Now this may be a contrarian indicator for those looking to short the recent run-up in energy prices, but it may also speak to the structural shift in energy production and transportation under way here in the U.S.

If all of these signs point to a more consistent, more reliable U.S. energy sector,  the time to get back in may be staring you in the face.

At the time this article was written, the author held no positions in the securities mentioned. Contact Paul Baiocchi at pbaiocchi@indexuniverse.com .


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