Energy’s supply/demand outlook makes it a no-brainer for maintaining exposure to oil and oil-related assets over the long haul. But what about the short term? At the moment, there’s reason to wonder, in part because oil and oil stocks have had such an extraordinary run in recent years.
The performance of the Energy Spider (Amex: XLE), which represents the energy stocks in the S&P 500, towers over the stock market for last three years through yesterday, according to Morningstar. XLE posts 33.7% annualized return as of March 8. That’s nearly double the S&P 500’s advance. Meanwhile, the relative market cap of energy keeps climbing in the S&P 500. The energy sector currently represents about 9.5% of S&P 500 market cap–a rise of about one-third from a year ago, which is by far the biggest increase among the ten sectors.
What’s driving XLE? Surging oil prices, of course. A barrel of crude oil currently changes hands at about $60, or more than twice the price of three years ago.
The case for projecting higher oil prices for the years to come has merit, but expecting crude to keep up the pace of the last three years may be asking too much. Indeed, even the super oil bulls don’t think crude will double in price every three years going forward. A few analysts think $100 a barrel is possible in the near future, but that would represent a 66% gain from current levels. And once we’re at $100 a barrel, then what? Two hundred bucks? Don’t hold your breath unless you’re thinking in terms of five, ten and 20 years.
True, anything’s possible when it comes to the world’s most valuable commodity. One “event” could change everything. But waiting for the world to end is questionable as prudent investing strategy. Then again, even in the best of times crude oil is priced by its own strange rules, which are influenced by any number of variables that don’t otherwise pervade commodity pricing.
In sum, oil prices may have reached a permanently higher plateau, but further increases from this point may be more measured, not to mention widely anticipated. In fact, there’s reason to at least consider scaling back one’s expectations for earnings performance in oil stocks. In fact, that seems to be happening, at least when it comes to analysts’ estimates.
Analysts’ projections for earnings in energy sector of the S&P 500 tell the story, as the chart below illustrates. After enjoying a long stretch of 40%, 50%, and even higher year-over-year comparisons in earnings increases, the energy sector’s outlook is one of moderating optimism. And to the extent one wants to believe the projections, analysts predict that energy earnings in the fourth quarter of 2006 will post their first decline relative to the previous year’s quarter for the first time in recent memory.

“Energy is expected to lose earnings share in 2007, as growth is forecast to be lower than that of the overall market,” writes Dirk Van Dijk of Zacks.
One could argue that oil stocks will need a large bump in energy prices in the near term to maintain the stellar record of increases that oil stocks have posted of late. But what if $60 a barrel remains the norm for some time? “Absent further large increases, energy stocks have probably lost at least one powerful driver of performance,” writes Michael Krause of AltaVista Independent Research, in a research report published yesterday.
Meanwhile, volatility in the Energy Spider has been on rise lately, with the standard deviation of the ETF’s price more than doubling from 2003. The implication: XLE faces the prospect of slower earnings growth amid rising price volatility. “Because XLE now appears more reasonably valued based on current fundamentals, the machination of politics in oil exporting countries has taken on increased importance since the daily fluctuation in the price of oil now has more impact on value investors assign to energy profits,” Krause writes.
Yes, the case for energy-related investments still looks good for the long term, but getting there first requires surviving the short term.