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June 23rd, 2012 by

Don’t get burned by Energy

This year was not kind to investors investing in the energy sector. The sector is the worst performing sector year to date, as measured by the Energy Select Sector SPDR (XLE) from State Street, with negative 7.43% for the year and severely underperforming the S&P 500 ETF (“SPY”) by 14.79%.

Sector Ticker YTD Return YTD over SPY
Technology XLK

12.70%

5.34%

Discretionary XLY

11.74%

4.38%

Financials XLF

11.12%

3.76%

Healthcare XLV

8.99%

1.63%

Staples XLP

5.64%

-1.72%

Industrials XLI

3.92%

-3.44%

Materials XLB

3.04%

-4.32%

Utilities XLU

1.71%

-5.65%

Energy XLE

-7.43%

-14.79%

SPY

7.36%

0.00%

S&P

6.16%

-1.20%

As of June 22, 2012

What a difference a year makes. Last year, for the January to May period XLE was the second best performing sector and a top performing sector for many months before that. What happened? Is the sector oversold? Is it going to bounce back or is there something else?

The main and most basic reasons for poor sector performance come from the fundamental demand perspective – simply speaking the world is in recession and the demand is lower. The oil is trading below  $80, quite a bit cheaper than year ago. Although the US economy is improving somewhat, the demand from Europe and slowing down of Chinese economy are the key demand drivers that are slowing down the
sector.

So what should we expect from the Energy sector for the rest of the year? Should we expect it to bounce back or will it stay on the bottom of the performance charts for the rest of the year.

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

The first one is a fight between Saudi Arabia and other “moderate” countries trying to keep the prices stable without shocking the world economies even further, while another group, led by Iran and Venezuela, is trying to decrease production in order to push prices higher. 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 a possibility of military conflict with Iran have actually increased since the negotiation between the US and our allies and Iran have pretty much broken down. If there is a conflict, the oil prices will sky rocket.

So overall we have a lower world demand, with stable supply, which can potentially keep the oil prices at the same level or lower, but an uncertainty of political/military events raise a possibility of a singular oil price spike.

If one could venture to put odds to this, I would guess that most likely the oil prices will continue to drift down, with a very small chance of an upward spike.

Being conservative investor I would 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, or buy an inverse ETF (“DNO”) or  double inverse oil ETFs (“SCO”).

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

 

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

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Category: XLE

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