Analysis: When To Switch Horses
Energy stocks have benefited from the recent surge in crude prices. During March, WTI crude futures spiked to a monthly average of $103 per barrel, up 15% from February's average of $90 per barrel. In similar fashion, the S&P Energy Sector (comprised of 40 companies) improved 16.3% during the first quarter of 2011. We would note this is 3 times the broader market's average performance over the same period, as the S&P 500 index returned 5.4%.
With oil hitting and now coming off a new peak, as traders continue to watch the volatility and react to the troubles in North Africa/Middle East, along with the daily gyrations of the U.S. dollar; this seems a good time to delve into the cyclicality of the energy markets and some implications.
We calculated and made observations based on relative betas and stock price performances over the last five major trading cycles, comparing the S&P Energy Sector's constituents against the overall sector itself. Our goal was to map each constituent's trading patterns relative to the S&P Energy Sector index in order to determine the strongest gainers and most consistent energy stocks during both up and down cycles.
On average, energy stocks exhibiting the highest betas relative to the S&P Energy sector outperformed the sector during upswings and underperformed during declines. While the averages were consistent with our expectations, we did find some anomalies. Two of the top-three gainers (Tesoro averaged +542%, Southwestern Energy averaged +344%) when cycles trended upwards were companies exhibiting betas of less than one. Both companies however had short-term betas that well exceeded the norm during the August 5, 2002 to May 5, 2005 time-frame when each achieved the bulk of their returns for all five of the up cycles. Moreover, Tesoro actually posted negative returns during two of the five upcycles. From a vantage looking for consistency, the biggest standout during the five upswings was National Oilwell Varco. NOV was the only member of the S&P Energy Sector to post triple-digit gains over four of the five cycles.
The fact that higher beta stocks on average outperformed lower beta stocks during upswings should come as no surprise. However, the average superior performance by high beta energy stocks during good times was quite extraordinary. Before we get into these details, we draw your attention to the following table as it provides a breakdown of betas not just by company but also by industry groups.
We would note that the line of distinction between high betas and low betas is one. All stocks with a beta greater than one were considered high beta stocks for the averages in the tables. Conversely, all stocks with betas less than one were considered low beta stocks when averages were calculated. As the following table presents, average returns of high beta energy stocks were nearly twice the average of all other energy stocks in the S&P Energy Sector during upswings.
The next table illustrates that lower beta energy stocks perform better than both higher beta stocks and the average for the S&P 500 Energy sector during downturns. Interestingly, in a depressed market for energy the disparity between high and low beta stocks is not as noticeable as what occurs when energy stocks are on the rise. Still, observations of historical data clearly indicate that when it comes to playing the energy markets; optimal returns require investors to switch between high and low beta stocks depending on the direction of overall trend of the energy sector.
During cycles where a stock's beta was at odds with its long-term beta, the average performance was included with the group to which its short-term beta corresponded. Interestingly, there were just a few stocks whose betas for each cycle were entirely consistent with their long-term beta, whether they were high or low beta stocks.
National Oilwell Varco and Rowan Companies were the only two high beta companies that exhibited high betas during all of the cycles. Exxon Mobile, ConocoPhillips, Murphy Oil, EQT Corp, Marathon, Chevron, and Sunoco were the only low beta companies that exhibited this trait through each of the cycles. The remaining 31 companies flip-flopped at least once or did not participate in all the cycles.
The Cyclical Nature of Energy Stocks
A round trip, in trading terms, occurs when a company or industry experiences significant gains over a period of time and then subsequently falters with prices returning to levels seen before the original surge. The circled area in the chart above illustrates a recent example of a round trip pattern for an equally-weighted portfolio of the forty stocks that are constituents of the S&P Energy Sector. Prior to the recent uptrend in the energy markets that began last September, the return for the past five years was just 10% or +1.9% per annum (from Aug. 31, 2005 Aug. 31, 2010).
We point this fact out because people tend to remember the spike in oil in 2008 but do not recall that oil prices from Aug '05 to Aug '10 oil prices only changed by 4%. So, while timing the markets is generally thought of in abhorrent terms and not considered a valid investment strategy; the buy-and-hold strategy applied to energy investments would typically result in inferior returns relative to the broader markets over the long run.
An alternative strategy for playing the S&P 500 Energy sector would be to take a market neutral position (i.e. long/short). We would note that historical returns are not a predictor of future performance. With that said, the best long/short idea based on both stock performance and betas over the past three years would be going long a coal producer and shorting a refiner, as playing these two industries against one another would likely produce the greatest alpha (i.e. farthest distance between y-intercepts). However, in an environment where the energy sector is trending down on lower commodity prices, the favorable long/short play would be long integrated oil companies and short oil field service firms.
The following table provides both betas and stock performances for the entire S&P Energy Sector with the last five up cycles and the last five down cycles averaged for each firm. The betas were calculated over the past 15 years and the stock performances are for major cycles occurring over the past 10 years.
A complimentary spreadsheet that includes all supporting information used in this article is available upon request to all our Riglogix subscribers. Simply email email@example.com with "Beta Request" in the subject line. Those interested in a subscription to Riglogix should contact firstname.lastname@example.org.
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