XLE: W-Shaped Recovery Most Likely Scenario For Energy Sector (NYSEARCA:XLE)

Amid the coronavirus black swan, the bottom fell out of the energy sector, which was already down 40% from its peak prior to the pandemic based on the sector ETF (XLE). The double whammy of immeasurable collapse in demand and geopolitical shocks led to another ~60% collapse before a massive relief rally alongside broader markets took place.

As of 4/24/2020. Source: WingCapital Investments

The unprecedented price destruction meant the energy sector’s weight in S&P 500 (SPY) has dropped below a minuscule 3%.

Source: Bloomberg

One seemingly positive development is that XLE was able to continue its furious rebound off the lows despite the carnage in crude oil prices below zero. Indeed, XLE has completely diverged from crude oil since the end of March:

Source: WingCapital Investments

Positive Divergence Between XLE and Crude Oil Not Necessarily Bullish

As a result of the polar opposite performance in XLE and crude oil, the ratio between the two (XLE/CL1) has launched to the highest ever. That said, we reckon the phenomenon is actually not as bullish as it seems, especially during a bear market. Historically, we observe that there were only 2 other times in the last 20 years during which:

  • XLE rallied 5% or more in the past 4 weeks
  • while crude oil dropped by at least -5% at the same time
  • and XLE was negative in the past 52 weeks

Source: WingCapital Investments

Without a surprise, the two instances were 2001 post-9/11 and 2008 Great Recession market turmoil, during which XLE also rebounded off the lows while diverging positively from crude oil. Though, the relief rally would run out of steam in both cases with more downside in the ensuing 1-3 months:

Date XLE CL1 XLE Past 52-Wk Chg XLE Past 4-Wk Chg CL1 Past 4-Wk Chg XLE Forward Chg 1-Month 3-Months 6-Months 12-Months
2001-10-15 26.95 21.83 -18.49% 7.46% -15.94% -6.12% -5.19% 6.75% -16.03%
2008-11-03 49.85 61.04 -33.04% 14.86% -21.44% -11.41% -5.88% 3.99% 14.50%
2020-04-06 33.91 22.76 -49.81% 5.34% -28.27%

Below shows the trajectory of XLE after initially diverging from crude oil during 2001 and 2008, both of which whipsawed to lower lows (-20% drawdown) in a W-shaped consolidation over the following 2 years.

Source: WingCapital Investments

Firesale Valuations In Top Holdings Put A Floor Under XLE

The unprecedented plunge in crude oil prices has no doubt created an existential crisis for many energy companies. Indeed, following the footsteps of Whiting Petroleum (WLL), Diamond Offshore Drilling (DO) filed for bankruptcy with debts of more than $2.6bn per Financial Times. Moreover from Advisor Perspectives:

A recent Dallas Federal Reserve Bank survey found that the average WTI price necessary to cover operating expenses in the region was $30 per barrel. In a recent Kansas City Federal Reserve Bank survey, nearly 40% of the oil companies said that they would be insolvent within a year if oil prices were to stay at $30 per barrel.

The uncertainties surrounding the viability of the industry as well as margin call-driven sell-off in the broader market led to bulk of XLE’s top holdings trading deep below their tangible book value. Though, investors were quick to scoop up energy stocks under such firesale valuations, as the subsequent rally drove price-to-tangible book value ratios back above one for most names:

Symbol Name % Weight Price/Tangible Book Value (52-Wk Low)

Price/Tangible Book Value (4/24)

CVX Chevron Corp 23.94% 0.69 1.17
XOM Exxon Mobil Corp 22.36% 0.67 0.97
EOG EOG Resources Inc 4.53% 0.73 1.17
COP ConocoPhillips 4.48% 0.65 1.12
PSX Phillips 66 4.44% 0.85 1.30
WMB Williams Companies Inc 4.20% 1.90 4.12
KMI Kinder Morgan Inc Class P 4.15% 1.74 2.72
SLB* Schlumberger Ltd 3.91% N/A N/A
VLO Valero Energy Corp 3.91% 0.60 1.01
MPC Marathon Petroleum Corp 2.96% 0.73 1.23
XLE Top 10 78.88% 0.78 1.29

*SLB is N/A due to negative tangible book value. Source: Seeking Alpha

Without questions, near-term fundamentals are more than gloomy for crude oil with conventional storage expected to run out of space by next month. That being said, we reckon large cap energy companies with robust balance sheets will most likely be able to ride out the storm until supply and demand eventually strike a balance. In the case of XLE, 6 of the top 10 holdings including the top 5 names which account for nearly 60% allocation of XLE, have solid debt-to-equity ratios well below 1:

Source: Seeking Alpha

Another leverage measure based on net debt / forward EBITDA ratio is also manageable for most names except for WMB and KMI. While the heavy debt load for the more distressed names is concerning, interest coverage ratio (forward EBIT / net interest expense) remains above 2.0, suggesting they are not in an imminent solvency crisis.

Symbol Name % Weight FWD EBITDA Growth Net Debt / Fwd EBITDA FWD EBIT Growth Forward EBIT / Net Interest Debt To Equity
CVX Chevron Corp 23.94% -15.69% 1.03 -33.03% 8.79 0.21
XOM Exxon Mobil Corp 22.36% -18.76% 2.00 -29.49% 9.88 0.27
EOG EOG Resources Inc 4.53% -15.49% 0.60 -49.74% 11.58 0.28
COP ConocoPhillips 4.48% -22.57% 0.53 -51.78% 5.86 0.45
PSX Phillips 66 4.44% -15.58% 2.93 -16.53% 6.58 0.48
WMB Williams Companies Inc 4.20% 2.81% 5.21 50.96% 3.10 1.37
KMI Kinder Morgan Inc Class P 4.15% -1.18% 5.58 -0.24% 2.16 1.02
SLB Schlumberger Ltd 3.91% -20.71% 2.65 -39.96% 3.10 1.04
VLO Valero Energy Corp 3.91% -9.88% 1.51 -14.17% 7.34 0.49
MPC Marathon Petroleum Corp 2.96% 2.78% 2.99 -5.20% 4.80 0.73
XLE Top 10 78.88% -14.45% 2.00 -25.29% 7.81 0.44

Source: Seeking Alpha

While solvency concerns are not going away in the face of dire fundamentals, most of the $86bn in energy corporate debt does not mature until 2022 and beyond as pointed out by CNBC. Although more bankruptcies are inevitable for the smaller, vulnerable companies as the bust cycle continues to play out, the rock-solid names held by XLE are expected to survive and thrive once the dust settles. At the same time, any potential recovery will most likely be a drawn-out process similar to past bear markets in 2001 and 2008.

To conclude, technicals and fundamentals point to a multi-year W-shaped consolidation in the energy sector. We anticipate selling pressure to resume in XLE with recent lows to be retested, while expecting strong buying interest upon valuations dropping once again towards deep bargain levels.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: We may have options, futures or other derivative positions in the above tickers mentioned.

Editor’s Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.

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