The Fundamental And Technical Case For Buying The Energy Sector Now

Oil prices have tumbled 30% since July amidst a rising greenback and abundant supply gushing from the fracking boom here in the U.S. However, the energy sector’s four-month-long downtrend appears to be waning. Technical and fundamental evidence suggests that most of the correction has passed. The recent sell-off has made a bargain-buying opportunity in energy -- the most oversold sector in the S&P.

Selling onslaught in mid-October shows the sellers have all given up on the trade.

“Based on the intensity of down volume (selling) relative to up volume (buying), the energy sector hit capitulation levels in mid-October not seen since the 2002 low,” Stephen Suttmeier and Jue Xiong, Bank of America Merrill Lynch analysts wrote in a client note Nov. 11.  “Downside volume capitulation off key support suggests that the worst is over for the sector. Energy is poised to build a base and head higher.”

The energy sector seems to have found buying support at the 2011 price peaks and an uptrend line that goes back to early 2009. Market sentiment, as gauged by Market Vane’s Bullish Consensus, and momentum, as gauged by Relative Strength Indicators, have both touched multi-year extremes from which uptrends have commenced, Xiong and Suttmeier added.

New long-term development needs Brent Crude Oil to trade at $100 a barrel long term, BofA Merrill’s analysis concludes. Production in the Permian, Eagle Ford and Bakken require oil prices of $50 to $70 a barrel to make a reasonable 15% return on new investments. Therefore, output is still economically viable if crude is trading in the mid 70s as of mid November.

Integrated oil corporations are restructuring and downsizing their operations, which should increase earnings, say analysts.

“Production growth has been difficult, but we think project start-ups and natural gas and LNG growth, particularly in Asia, will drive growth over the next five years,” Stewart Glickman, an analyst at S&P Capital IQ wrote in a report Nov. 15.

Oil demand globally should climb by 900,000 barrels a day in 2014 to 92.6 million barrels a day, Glickman added using data from the International Energy Agency. The IEA forecasts global demand will jump by 1.2 MMb/d to 93.8 MMb/d in 2015.

The energy sector is undervalued relative to the stock market. The Energy Select Sector SPDR ETF (ARCA:XLE) carries a price-to-earnings ratio of 14.7 vs. almost 18 for the SPDR S&P 500 ETF (ARCA:SPY). XLE is trading at 1.8 times book and 1 times sales, which is much lower than the S&P, which is trading at a price-to-book ratio of 2.5 and price-to-sales ratio of 1.7.  XLE’s foreign peer, SPDR S&P International Energy Sector ETF (NYSE:IPW), is trading at only 12 times prospective earnings, 1.3 times book and only 0.6 times sales with a dividend yield of 4%, according to Morningstar.

Cheap valuations present opportunities for mergers and acquisitions as seen in Halliburton’s (NYSE:HAL) proposed acquisition of Baker Hughes (NYSE:BHI). If the combination of the second- and third-largest oil services companies makes economic sense, so would the takeovers of their smaller peers.

The largest stocks in XLE have been very amiable to buying back their own stock this year. This juices earnings per share and supports demand for shares. Exxon (NYSE:XOM) -- the biggest holding in XLE -- repurchased $3 billion of its stock in Q3. It intends to buy back another $3 billion of its shares in Q4. Chevron (NYSE:CVX) bought back $1.25 billion of its stock in Q3 in an existing $1.25 billion-quarterly share repurchase program.  A share repurchase plan started in July 2010, permits Chevron to repurchase $500 million to $2 million of its stock every quarterly. Chevron’s 10-Q filing it issued Nov. 11 stated its repurchase plan has no monetary or term limits. The board of directors at Schlumberger (NYSE:SLB) started a $10 billion buyback plan in July 2013. Over first three quarters of this year, Schlumberger has repurchased $3.5 billion of its shares.