- U.S. energy stocks continue to trade at incredibly low levels relative to the ongoing rally in the S&P 500 and crude oil prices.
- Based on the historical correlation between the XLE/SPX ratio and oil prices, the ongoing crude oil recovery suggests the XLE/SPX ratio should be trading more than double current levels.
- The energy sector’s forward dividend yield is now 3.3x greater than the broader market, which is 4 standard deviations above its long-term average of 1.3x.
- The close correlation between XLE and 10-year breakeven inflation expectations highlights the energy sector’s usefulness as an inflation hedge.
U.S. energy stocks continue to trade at incredibly low levels relative to the ongoing rally in the S&P 500 and crude oil prices. Concerns over stranded assets and the impact of ESG-focused investment mandates have kept energy stocks out of favour, providing an extremely positive risk-reward trade-off.
The Energy Select Sector SPDR ETF (XLE) has continued to languish near multi-year lows despite the recovery in oil prices, energy sector credit, and the SPX. Periods of rising energy prices and a rising SPX have tended to be extremely bullish for energy equities but the sector has struggled amid fears over its long-term viability. Notwithstanding the long-term headwinds facing the sector, its underperformance relative to the market amid the recovery in crude prices presents an opportunity.
Energy Stocks Have Yet To Rally In Line With Crude, Credit, and Stocks
The ratio of the XLE over the SPX has tended to closely track the real oil price over the past few decades. Based on this close historical correlation, the recent recovery in crude oil suggests the XLE/SPX ratio should be trading more than double current levels. As the recent recovery in oil prices feeds through into a recovery in earnings, we should see XLE begin to outperform.
Source: Bloomberg, Author’s calculations
The fact that oil prices have recovered strongly from their April crash explains why analysts see only minimal further cuts in the MSCI USA Energy dividend payments, which the XLE tracks. The Bloomberg estimated forward dividend yield for the index sits at 5.8% compared to 1.7% for the SPX. Investors are therefore expecting energy stocks to deliver 3.3x greater dividends than the broader market, which is 4 standard deviations from its long-term average of 1.3x.
MSCI USA Energy Vs SPX Dividend Yields, %
Energy Stocks Are A Good Inflation Hedge
Yesterday’s pullback in gold prices has done little to alter our view that inflation pressures are building across the U.S. and global economy, and energy stocks provide a good hedge against a sharp rise in price pressures. Periods of high inflation have tended to occur alongside rising oil prices, and while in part this has been a result of oil price shocks driving up inflation, it has also reflected the tendency for oil prices to respond positively to monetary debasement. The close correlation between XLE and 10-year breakeven inflation expectations highlights the sector’s usefulness as an inflation hedge. Again, the recovery in inflation expectations suggests energy stocks are far too cheap.
XLE Vs 10-Year Breakeven Inflation Expectations
High Energy Sector Volatility Warrants A Nuanced Approach
The XLE tends to be roughly three times more volatile than the SPX meaning that an equally-weighted long-short position could underperform in the event of a broad equity market decline. One option is to short more units of the SPX for every long unit of the XLE. Another option is to short crude oil itself in addition to going long XLE and short SPX. This would protect against the potential for XLE to underperform once again in the event of a resumption in oil price declines.