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Finance

Is this the START of an Energy Bull Market?

  • News of a COVID-19 vaccine ignites a recovery in energy stocks

  • The new administration could be bullish for the fossil fuels they want to eliminate

  • Three reasons for a significant rally in energy stocks- Rotation, inflation, and re-socialization

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  • XLE and VDE are diversified products that stand to gain

  • OIH has suffered; it could make a stunning reversal

Energy stocks have been pariahs over the past years. As the stock market rallied to higher highs, energy stocks stood on the sidelines and did not participate in the bullish price action. When stocks corrected, the energy sector often led the way on the downside. COVID-19 made a bad situation worse for the energy sector, sapping any chance of recovery from the stocks as the demand for crude oil and other hydrocarbons plunged.

Last week, the world experienced two watershed events that could change crude oil and other fossil fuels’ fortunes. The United States elected Joe Biden as its forty-sixth President. Two days after declaring victory in a close contest against incumbent President Donald Trump, one of the leading drug companies, announced positive results on a vaccine for the virus that continues to plague the world. The stock market roared higher on November 9. The leader was the forgotten redheaded stepchild of the market, the forlorn energy sector.

A recovery in energy stocks had been long overdue. Only the leading companies with the most robust balance sheets are in a position to benefit. However, we could see share prices fly higher as pent-up demand and sector rotation returns to the companies that continue to power the world.

News of a COVID-19 vaccine ignites a recovery in energy stocks

On Monday, November 9, Pfizer (PFE) told the world that its vaccine trials showed a 90% effectiveness. Even though coronavirus cases and hospitalizations are surging, the news put a bright light at the end of the pandemic’s dark tunnel.

The stock market exploded higher last Monday. Technology stocks did not lead the charge. The NASDAQ was the only leading equity index that settled lower on the session. Energy, the market sector that had been flailing long before the outbreak of COVID-19, led the stock market higher.  The Energy Select SPDR (XLE) is a diversified product with the highest level of nets assets. The XLE experienced its most substantial rally in a long time on November 9 after Pfizer’s announcement. The potential for a return of demand for the energy markets drove investors and traders into the sector.

Source: Barchart

The chart shows that the XLE rose from $28.93 at the close on November 6 to a high of $34.57 on November 11, a rise of 19.5% on the back of the vaccine news. The XLE closed at the $33.88 level on November 13, not far off the high for the week.

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The new administration could be bullish for the fossil fuels they want to eliminate

The demand side of the fundamental equation has weighed on energy prices in 2020. The global pandemic has been a hugely bearish factor. After reaching a high of $65.65 per barrel on the nearby NYMEX WTI crude oil futures contract in January and almost $72 per barrel on Brent futures at the same time, COVID-19 drove prices into a bearish abyss in April. Brent fell to the lowest price of this century, while WTI declined below zero.

While President Trump, a huge advocate of US energy production, has yet to concede the election, the writing is on the wall as President-elect Joe Biden will take the Presidential oath and become the forty-sixth leader of the free world on January 20.

The incoming administration is not going to be as supportive of oil and gas production. Progressive Democrats favor limiting or banning fracking, the process of extracting oil and gas from the earth’s crust. More regulations under a Biden administration is likely to cause US production to decline. Meanwhile, a full-blown realization of the Democrat’s plan depends on winning a majority in the US Senate. A pair of runoff elections in Georgia on January 5 will determine if the Senate remains in the hands of Republicans or the Democrats take control. If Democrats can win the two runoff contests, US oil and gas output could drop like a stone as the regulatory environment would reflect as progressive rather than a moderate approach. Therefore, the future of US energy policy is in the hands of Georgia’s voters.

Since the US and world will continue to require fossil fuels as an energy source, a strict US regulatory environment could shift the influence in pricing power back to OPEC and Russia as the Middle East is home to over half the world’s crude oil reserves. Eliminating a substantial chunk of US output as the world emerges from the global pandemic would likely push energy prices a lot higher. The leading US energy-related companies that have survived years of underperformance could emerge. It is not unusual for the worst-performing sector over one period to become the best in the next period. After over two years of horrible performance, a recovery in energy is overdue.

Three reasons for a significant rally in energy stocks- Rotation, inflation, and re-socialization

In real estate, the mantra is always location-location-location. For the energy market, rotation-rotation-rotation could be appropriate as investors and traders look for value stocks as the bloom comes off technology’s rose. While higher regulation levels are in store for energy, the same holds for the high-flying technology sector and its oligarchs. Sector rotation could drive capital into the energy companies with the most robust balance sheets. In the US, Exxon Mobile (XOM) and Chevron (CVX) are the leading integrated energy companies. In Europe, British Petroleum (BP), Royal Dutch Shell (‘), and Total (TOT) offer value compared to the rest of the stock market. On November 9, all of these companies posted double-digit percentage gains.

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Sector rotation into energy is the first reason why the price action on November 9 could be the start of a new trend.

The impact of central bank liquidity and government stimulus over the past year will continue long after a vaccine becomes available. With more liquidity and stimulus than in 2008, the prospects for rising inflationary pressures that erode the US dollar’s purchasing power and all fiat currencies are bullish for all commodities prices, and crude oil is no exception. From the 2008 lows to the 2011 high, NYMEX crude oil climbed from $32.48 to $114.83. The XLE rose from $37.40 to $80.90 over the same period. Inflationary pressures would support earnings for energy companies and push share prices higher. Limiting US production under the Biden administration may only accelerate the upward trajectory of oil prices and profits for the leading oil companies.

Finally, the post-COVID-19 environment could be a period when the demand for energy skyrockets as people and businesses attempt to get back to normal. Re-socialization in the aftermath of the pandemic would likely prop up the demand side of the fundamental equation for energy, offering gains for producers and other oil and gas-related businesses that survived the crisis.

XLE and VDE are diversified products that stand to gain

The XLE is a diversified ETF product that holds the cream of the crop in the sector, including:

Source: Yahoo Finance

XLE has net assets of $8.78 billion, trades over 29.1 million shares each day, and charges a 0.13% expense ratio.

The Vanguard Energy Index Fund ETF Shares (VDE) offers another option for exposure to the energy sector. VDE’s portfolio includes:

Source: Yahoo Finance

As you can see, the portfolios of the two ETFs are almost identical. VDE is smaller with net assets of $2.66 billion, an average of 881,652 shares changing hands each day, and an expense ratio of 0.10%, three basis points below the XLE.

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From the close on November 6 to the high of last week on November 11, XLE moved 19.5% higher., VDE moved from $39.15 to $46.59 per share or 19% to the upside over the same period. The XLE and VDE stand to gain if sector rotation occurs, inflationary pressure climb, and re-socialization occurs in 2021 and beyond.

OIH has suffered; it could make a stunning reversal

The subsector of the energy asset class that suffered the most was oil services. As oil and gas producers saw business decline, those companies that provided services did worse as the demand evaporated. The VanEck Vectors Oil Services ETF product (OIH) holds the leading services companies, including:

Source: Yahoo Finance

OIH has net assets of $406.81 million, trades an average of 416,707 shares each day, and charges a 0.35% expense ratio. From the close of business on November 6 to the high last week, OIH recovered from $100.50 to $123.18 per share or 22.6%. The worst subsector in the energy patch could be positioned to turn in the most significant recovery over the coming years.

The all-time high in the XLE and VDE was at $101.52 and $145.97 in 2014. OIH rose to a split-adjusted $1160.20 in 2014, and the all-time peak was at $1525 in 2008 when WTI crude oil futures hit its all-time peak at over $147 per barrel.

Energy stocks and those that service the sector offer tremendous value compared to the rest of the stock market. Time will tell if the price action last week is a bear market bounce or the start of a significant recovery.  There could be lots of room to rally if sector rotation is getting underway. If the stars line up for energy, we could see an explosive move over the coming months and years.

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USO shares were trading at $29.05 per share on Monday morning, up $0.92 (+3.27%). Year-to-date, USO has declined -71.65%, versus a 13.68% rise in the benchmark S&P 500 index during the same period.

About the Author: Andrew Hecht

Andy spent nearly 35 years on Wall Street and is a sought-after commodity and futures trader, an options expert and analyst. In addition to working with StockNews, he is a top ranked author on Seeking Alpha. Learn more about Andy’s background, along with links to his most recent articles. More…

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