- Energy stocks have been top performers this year.
- You can buy individual upstream, midstream, or downstream stocks, but each has its own pros and cons.
- An exchange-traded fund offers quick access to the biggest companies with less single-stock risk.
It’s been a bad year for the stock market.
Before last week’s impressive rally, the S&P 500 had flirted with a bear market (officially labeled as a 20% decline), while the NASDAQ remains firmly entrenched in one.
Yet, energy stocks have avoided the bear market so far.
It’s not surprising that they’ve performed well, given that commodity prices benefit when inflation rears its ugly head.
Still, the return of energy stocks may surprise you. For example, ExxonMobil (XOM) is up 63%, energy services behemoth Schlumberger (SLB) is up 61%, and energy drilling company Nabors (NBR) has more than doubled, rising 106% this year.
It’s hard to find an energy stock that isn’t up over 50% this year, which is pretty remarkable given the S&P 500’s down about 12%.
Given those returns, can you still buy energy stocks, and if so, what should you buy?
First, a little background
Energy stocks’ strength is due to a perfect storm. COVID-era monetary and fiscal stimulus designed to keep global economies afloat during shutdowns significantly increased access to cheap credit, priming the pump for explosive growth once shutdowns eased. As a result, soaring global activity substantially increased the demand for energy products.
At the same time, producers, including OPEC, which controls about 40% of global oil production and 90% of proven reserves, have kept spigots shut for fear high prices would prove a short-term phenomenon.
The gap between demand and supply widened further in February when Russia invaded Ukraine, resulting in sanctions reducing access to Russian energy products in Europe and America. Russia is the 3rd largest oil producer globally.
The result has been that oil and natural gas prices have remained incredibly sticky at historically high levels. The U.S. Brent Oil ETF (BNO) traded below $6 in early 2020 because of COVID fears. Today, it’s trading near $35, up 492% in two years. The Henry Hub Natural Gas spot price has increased 305% since its low in June 2020.
How you can play it
There are plenty of multinational, integrated large-cap energy companies to choose from. For example, Warren Buffett recently bought shares in Chevron (CVX) , America’s second-largest energy company. ExxonMobil, the largest energy company by market cap, operates globally, too, and it’s currently enjoying the benefits of new production from a major discovery offshore Guyana. Both have upstream (exploration and production), midstream (pipelines, storage, etc.), and downstream (refining and marketing of products like gasoline) assets, so you get exposure throughout the energy lifecycle owning these stocks.
You could also buy energy services stocks. These companies, including Schlumberger, Halliburton (HAL) , and Baker Hughes (BKR) , provide specialized equipment, parts, or expertise necessary for exploration and production.
Or you could buy companies that lease the rigs required to extract oil from the earth onshore, like Helmerich & Payne (HP) , or offshore, like Transocean Offshore (RIG) .
Similarly, you could buy shares in midstream players that generate revenue based on how much oil and natural gas are flowing through pipelines, or stored in facilities, like Hess Midstream (HESM) or Williams Companies (WMB) . Or perhaps, you could buy refiners, who turn these commodities into gasoline, diesel, or jet fuel, like Valero (VLO) .
There are endless possibilities, but each of these companies exposes you to specific risks. Understanding everything that can go right or wrong at these companies can be a full-time job.
So instead, a simpler option for gaining energy exposure could be buying the SPDR Energy Select ETF (XLE) .
In “We’re Initiating a Position in the Energy Sector,” Action Alerts PLUS Co-Portfolio managers Bob Lang and Chris Versace announced Tuesday that’s exactly what they’re doing. Initially, the position will account for 0.75% of AAP’s portfolio, but it could become bigger in time.
What prompted them to buy now?
There’s been a doubt that Europe, which is heavily dependent on Russian oil and gas, would come together on a plan to eliminate Russian supply. However, we learned over the weekend that Europe would ban most Russian oil and gas supply by the end of the year.
Lang and Versace write,
The XLE ETF makes sense to them because of its simplicity and liquidity. In their words, it “affords the portfolio wider spread and very liquid exposure to the energy sector (oil, gas, and consumable fuels) rather than owning one particular stock. This is in keeping with our strategy to selectively use a few ETFs in either a strategic or tactical fashion for the portfolio. XLE’s 21 holdings span Chevron, Exxon Mobil, ConocoPhillips (COP) , Marathon Petroleum (MRO) , EOG Resources (EOG) and bring with it a $2.80 per share forward dividend.”
In short, they’re making a broader bet that energy prices will remain high enough to fuel substantial industrywide profits. If they’re right, they won’t have to pick and choose individual stocks and take on stock-specific risks, and if they’re wrong, they can hit the sell button quickly to protect AAPs portfolio from large losses.
The Smart Play
Yes, you can buy energy stocks, but you’ll need to be careful because energy stocks are cyclical.
They do best when economies are humming and producers are gunshy. Historically, that’s made them top performers in the late stage of the business cycle when inflation runs hot because demand outstrips supply.
However, energy stocks struggle during a recession when slowing economic growth reduces demand. Moreover, declining demand caused by a downturn has a knack for happening just as producers finally open their spigots (greed eventually trumps prudence), causing oversupply and tumbling commodity prices.
Therefore, if the Federal Reserve overshoots, causing a recession, OPEC opens its spigots, and War in Ukraine ends, energy stocks could cool, causing losses in portfolios (Note: We’ll see what OPEC plans next for production on June 2).
For this reason, investors should consider energy stocks rentals rather than forever stocks.
Buying the XLE gives you quick exposure to all the big players, and its expense ratio is just 0.10%, so it doesn’t cost a lot to own it.
Importantly, owning this ETF means you can be nimble, and it won’t require a lot of work to manage the position, including the use of stop losses. If you’re just starting a position, consider investing in tranches like Lang and Versace. For example, you can begin with a 1% position and then increase or decrease it as your conviction changes.
If you’re interested in individual stocks, consider the Permian Basin plays. The Permian Basin in Texas is one of the most profitable formations, with breakeven levels as low as $35 to $40 per barrel. Chevron has over 2.2 million Permian acres, but purer plays like Pioneer Natural (PXD) and Diamondback Energy (FANG) are an option. Alternatively, consider the other upstream, midstream, and downstream names mentioned above.