Don’t Get Burned by Energy

By Alex Gurvich - July 6, 2012 | Tickers: XLE, SPY, SCO | 0 Comments

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This year was not kind to investors in the energy sector. And what’s worse, it is not likely to get any better. Slowing world economies and a lack of frightening war headlines keep energy stocks down. But there are ways for investors to make money from this.

How far down is oil and other energy producer stocks? Energy is the worst-performing sector year to date, as measured by the Energy Select Sector SPDR (NYSEMKT: XLE) S&P 500 ETF (NYSEMKT: SPY) by 13.34 percentage points. In fact, the energy exchange-traded fund is the only Standard & Poor’s 500 sector to lose money in 2012.     

As of June 26, total return.

What a difference a year makes. Last year, for the January-to-May period, XLE was the second best sector and a top sector for many months before that. What happened? Is the sector oversold?

The most basic reasons for poor sector performance are related to fundamental demand. Simply speaking, much of the world is in recession or close to it, and energy demand is lower. Oil is trading below $80 per barrel, quite a bit cheaper than year ago. Although the U.S. economy is improving somewhat, the downturn in Europe and slowdown in China are the key influences hurting the energy sector.

There are several additional factors in play that should not be overlooked. One is the continuous infighting among Organization of Petroleum Exporting Countries members regarding the level of production, while the other is the possibility of military conflict with Iran.

Within OPEC, Saudi Arabia and other moderate oil producers are trying to keep the prices stable to avoid weakening the world economies even further. Opposing them is a group seeking to push up prices. Led by Iran and Venezuela, it is trying to decrease production, which makes oil scarcer and thus pumps up its price. The good news, so far, is that the Saudi Arabia block is winning and we will most likely see continued stability of supplies.

On the other hand, the chances for military conflict with Iran have increased since the negotiation between the U.S. and our allies and Iran have pretty much broken off. If there is a conflict, oil prices will sky rocket.

So overall we have a lower world demand, with stable supply, which can potentially keep oil prices at the same level or lower, but political-military events could lead to a singular oil price spike. The odds are that most likely the oil prices will continue to drift down, with a very small chance of an upward move.

As a conservative investor, I say stay away from this sector until there is better clarity on the demand side. If you are more aggressive investor, you can short the XLE. For the truly adventuresome, there’s a double inverse oil ETF, which pays the opposite of what the market does, by two times, such as the Pro Shares  UltraShort DJ-UBS Crude Oil (NYSEMKT: SCO).

For someone who wants to live dangerously and play the geopolitical events, hedging in case of a military conflict with Iran, putting a small allocation to XLE would serve well.

Alex Gurvich is a portfolio manager and founding member of Rockledge Advisors in Brooklyn, N.Y.

At the time of publication, Rockledge clients had short positions in XLE in some portfolios. 

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