U.S. consumers have raked in savings at the gasoline pump in recent months in the wake of a 50 percent decline in crude oil prices since last summer. While the drop in energy prices has been a boon to consumers, the decline has hit energy stocks hard.
Why has crude oil been falling? It’s Economics 101. Crude oil prices have been driven lower by a basic supply and demand imbalance. As U.S. oil production climbed in recent years, boosted by the shale oil revolution, it bumped up the scales on global oil supply, turning it into a glut. In the first quarter of 2015, global energy liquids supply is estimated to total over 93.9 million barrels per day, versus global demand of 92.3 million barrels per day, according to a Morningstar Global Oil Update research report.
For long-term investors, the price drop in energy stocks and exchange-traded funds could offer opportunities to snap up some bargains. Although crude oil prices are low now, they may not stay that way for long. From 2011 to 2014, the annual average price for crude oil ranged between $93 and $95 per barrel, according to Barclays Research. The firm’s forecast for 2015 pegs crude oil at an average of $46 per barrel.
“The energy sector is the cheapest sector in the market right now. If oil prices do recover, the upside for these ETFs could be significant,” says John Gabriel, ETF strategist at Morningstar, a Chicago-based independent investment research firm.
When considering investments in the sector, know that not all energy stocks and ETFs are created equal, and a dart-throwing approach to stock picking may not work here. “If you want to participate in the recovery for oil, you want to pick the right horse,” Gabriel says. “There are about 25 ETFs that track the sector, but each has its own risk profile.”
Unless you are an active trader, you may want to avoid the United States Oil Fund LP ETF (symbol: USO), Gabriel says. “Stay away from it. It is only suitable for professional traders moving in and out very short-term,” he says. This ETF does not offer exposure to physical barrels of crude oil. Instead, the fund buys crude oil futures contracts. “The fund is investing in futures, and it does not track the market price of oil,” he explains. “For long-term investments, stick with equity ETFs that own the actual stocks.”
If you are looking for bargains in the energy sector, here are three choices experts recommend.
Energy Select Sector SPDR ETF (XLE). This ETF offers investors a wide range of exposure to the various industries within the energy sector, including exploration and production firms, oil and gas firms, refiners and even drillers. The 52-week high for this ETF stands at $101.52, and the 52-week low comes in at $71.70. In early April, XLE was trading at about $80. The annual expense ratio investors pay to hold the fund is a low 0.15 percent.
“Our favorite energy ETF is XLE,” says Todd Rosenbluth, director of ETF and mutual fund research at New York-based S&P Capital IQ, a financial information provider. Although crude oil prices are low now, “we think the trend will improve, and XLE is a good way to participate in it. It is heavily weighted toward the largest companies with strong cash flow to support dividends,” Rosenbluth says. “In the same way that some stocks pay a dividend, this ETF yields 2.5 percent, which is above average versus the broader market.”
The top three holdings in XLE are Exxon Mobil Corporation, Chevron Corporation and Schlumberger. “Exxon and Chevron have enough cash and continue to pay dividends. We think the dividends are stable,” Rosenbluth says.
Vanguard Energy ETF (VDE). This is similar to Energy Select Sector ETF, as the top three holdings are the same: Exxon Mobil, Chevron and Schlumberger. But there are differences between the two funds.
“This fund has about 160 holdings, versus XLE with 40 holdings,” Gabriel says.
The 52-week range, or the highest and lowest prices of the last year, for Vanguard Energy ETF is between $145.97 and $101.33, and the ETF traded at $112 in early April. This fund is slightly cheaper to own than Energy Select Sector ETF, with a 0.12 percent expense ratio. This choice is better suited for investors with a higher risk tolerance.
“We also do like the Vanguard energy ETF. It is a little bit cheaper. But it also has a little more exposure to smaller and medium-size companies, which in theory can do better,” Rosenbluth says. “But our fear is they will be more volatile. The fund is more industry-focused, and the narrower you get, the greater the risk. It is a little cheaper, but a little riskier.”
Encana Corporation (ECA). For investors looking for a stock investment, Encana is Morningstar’s top pick within the U.S. oil-focused exploration and production group. The company is involved in the exploration, production and marketing of natural gas, oil and natural gas liquids. The 52-week range for Encana is $24.83 to $10.53, and the stock recently traded around $11. Morningstar expects a current dividend of $0.25 per share, yielding roughly 2.1 percent per year, to be maintained.
“With limited leverage and a healthy improvement of drilling locations in high quality oil plays, the company looks well-positioned to cope with cheaper oil,” according to Morningstar. “Encana’s market value remains substantially below our fair value estimate, indicating that the market has overreacted to the oil slump. Encana is one of the more attractive defensive opportunities in this sector.”
The retreat in energy stocks and ETFs may offer investors the opportunity to capitalize on that tried-and-true investing wisdom: Buy low and sell high.
More from U.S. News
10 Commodities Investments to Rev Up Your Portfolio
7 Myths About Dividend-Paying Stocks
3 Investment Bargains in the Energy Sector originally appeared on usnews.com
