Since 2014, the energy sector has been among the worst performing sectors of the S&P 500. There have been several catalysts for this underperformance, including both supply/demand changes that have hampered oil pricing as well as company specific dynamics that have deterred investors. Below, we will reflect the magnitude of underperformance as well as some of the main causes of these issues.
In terms of performance, energy has been the worst performing sector dating back to 2007 and has an annualized return of -4.48%1 through the first half of 2020. The energy sector has underperformed the market:
- 7 out of the last 9 years
- 8 out of the last 13 years
The “return quilt” below reflects the annual performance of different sectors of the S&P 500. Energy, as depicted in green, shows that Energy has been the worst performing sector in 5 of the last 7 years.
Further, the chart2 below depicts the performance of the Energy Sector ETF (XLE – black line) and the S&P 500 (IVV – blue line). Note that up until 2014, energy stocks were outperforming the market, but has since declined precipitously while the market has surged ahead.
One of the most significant changes has been the “Shale Revolution” that began in the late 2000s and the 2010s, which made the US one of the largest producers of both crude oil and natural gas. In 2017, the Oil and Gas industry accounted for roughly 9.4%3 of GDP and employed about 10.3mln people in the US4. Although the Oil and Gas industry in the US has grown dramatically from the 2000s, this has caused a significant change in the supply/demand relationship as the US has become a very large incremental supplier without a significant change in the overall demand. This has a negative impact on long term pricing which can be seen in the below chart.
Within the sector, there is has been a further driver of increased debt on the balance sheets of energy companies. During the “shale boom”, energy companies spent wildly, with little discipline, in order to increase the capability of producing oil. In order to pay for that spending, companies had to borrow heavily. The heavy borrowing left little amounts of cash to return to shareholders in the form of dividends and buybacks. Additionally, when oil prices decline, oil and gas companies generate less revenue and lower profitability, which creates higher probability for default and can create a vicious cycle if oil prices stay depressed. The combination of the lack in discipline of spending and increased debt levels have caused investors to exit the space for better performing sectors.
In summary, the energy sector has underperformed the broad market significantly as a result of market oversupply and low levels of discipline on debt in a reduced profitability environment. Recently, energy companies have begun taking a more disciplined approach to production and spending to provide greater profitability and return to shareholders. attempting to return cash to shareholders. Time will tell how these cyclical forces of supply and demand play out, but energy companies that are prudent in capital allocation may be able to begin the process of reversing these recent negative trends for the overall sector.