The energy sector has been a bright spot in a challenging market, with energy being the only sector with positive returns year-to-date.
While the rest of the market is struggling, the energy sector is up about 68% year-to-date. The sector was also the top performer in 2021, as it finished the year with a total return above 53%, compared to the S&P 500’s total return of 27% during the same period.
Now, some investors are worried that energy stocks and ETFs might be due for a pullback after two years of outperformance; however, investors can find comfort in OPEC+ having shown that it is willing to defend prices around $90 per barrel of Brent crude oil, VettaFi head of energy research Stacey Morris said on ETF Spotlight with Neena Mishra on Thursday.
Morris said she is constructive on oil, although there are many moving parts. While the largest downside risk to oil prices is a recession, even in that case, OPEC+ will likely be willing to step in and make production cuts to offset any changes to demand, Morris said.
While the energy sector has posted impressive returns in the past two calendar years, those returns are coming off a particularly low base. The sector is now rallying nicely after underperforming for much of the last decade, but it’s by no means a space that has become expensive.
“I think the space can continue to do well, especially if we see this current dynamic continue, where you have high inflation and rising interest rates,” Morris said. “I don’t think we need oil to necessarily go a lot higher for the energy space to work, but if we have general stability or some kind of mild increase in oil prices, that would certainly help. But I think this space can continue to work. Companies are executing well, they’re generating free cash flow, they’re giving that cash back to investors, and I think that gets noticed and appreciated over time.”
Morris said companies across the industry are focused on capital discipline and generating free cash flow — and returning that cash to investors. The years of growth for growth’s sake are behind energy companies.
Understanding the 2 Energy Subsectors and How to Get Exposure to Each
Morris and Mishra explained that there are three different subsectors in the energy sector, each with different sensitivities to oil prices and interest rates.
Upstream comprises oil and gas producers, also called exploration and production companies — ConocoPhillips is an example. Oilfield services work very closely with upstream to help facilitate actual production, Morris said. These companies tend to be more sensitive to what is happening with commodity prices.
Midstream predominately includes pipeline companies, which are those that perform the shipping and handling function in the energy value chain. This segment is unique, as it tends to have less volatility and the least direct commodity price exposure, as midstream companies earn fees for services, leading to very stable cash flows.
Downstream refers to the companies that are closest to the end user, including refineries, gas stations, and petrochemical companies. Morris said refiners tend to be sensitive to what’s happening in commodity prices, but that has more to do with the spread between their input costs (crude oil) and their output (gasoline and diesel).
Working across the value chain, there are integrated majors like Exxon and Chevron. These companies have upstream arms where they’re producing oil and gas and downstream arms where they’re refining oil. Morris said that they often have chemical businesses, and many of them have growing renewable portfolios as well.
Mishra pointed to the Energy Select Sector SPDR Fund (XLE ) and the Vanguard Energy ETF (VDE ) as popular, low-cost funds offering exposure to the entire energy sector. XLE and VDE, however, are market cap-weighted, with energy giants Exxon and Chevron accounting for nearly 40% of the funds’ portfolios.
Morris said that investors bullish on commodities prices might want to consider a fund focused on exploration and production, like the SPDR S&P Oil & Gas Exploration & Production ETF (XOP ).
The oilfield services subsector tends to be dominated by the VanEck Oil Services ETF (OIH ), Morris said. The oilfield services subsector has seen a boost in recent weeks due to better-than-expected third quarter earnings coupled with positive outlooks for the space, Morris said.
Investors more concerned about volatility or those who think commodities prices will sell off might want something more defensive, like midstream. According to Morris, the midstream space is also well known for its income: MLP yields are around 7%, while broader midstream yields are around 6%.
The largest fund in the midstream subsector is the Alerian MLP ETF (AMLP ). AMLP offers investors the opportunity to invest in MLPs through an ETF. The fund is primarily used for income, offering the potential for tax-deferred income.
Another fund in the midstream space, the Alerian Energy Infrastructure ETF (ENFR ), is RIC-compliant, which caps MLP exposure at 25%. The other 75% of the portfolio is U.S. and Canadian energy infrastructure corporations. ENFR and other RIC-compliant ETFs tend to be more focused on total return as opposed to income.
Most investors get exposure from plain vanilla index funds, leaving them underexposed to the energy sector. Before 2014, energy was 10%–12% of the S&P 500 by weighting, but that gradually fell over time, bottoming at 2% in October 2020. Despite two years of outperformance, the energy sector still accounts for just about 5.6% of the S&P 500 Index.
Benefits of Energy Exposure in a Portfolio
One benefit of investing in energy companies is the attractive income they provide. Morris said that many exploration and production companies have adopted variable dividend payouts, meaning that when they make a lot of money, they pay out a lot of money.
“The yields on things like the XOP and XLE are well above what you can get on the S&P 500,” Morris said. “Of course, the midstream energy infrastructure space has always been known for its income.”
Morris said another benefit of having energy exposure in your portfolio is that energy tends to do very well in periods of high inflation, which has certainly played out over the last two years.
“I would argue there’s less sensitivity to rising interest rates,” Morris said. “It’s not like tech or some of these growth sectors heavily dependent on debt. Energy companies have done a lot to improve their balance sheets over the last several years.”
For more news, information, and strategy, visit the Energy Infrastructure Channel.
vettafi.com is owned by VettaFi, which also owns the index provider for ENFR and AMLP. VettaFi is not the sponsor of ENFR and AMLP, but VettaFi’s affiliate receives an index licensing fee from the ETF sponsor.