Energy: American Success Story

12/30/2013 8:00 am EST

Focus: ENERGY

Michael Burnick

Editor, Real Wealth Report

Which sectors with lackluster returns this year are the best candidates to rebound in 2014? asks Mike Burnick. In Money and Markets, he notes that industries at the back of the pack one year often rise to the top in following years.

That is the time-tested dynamic of mean reversion, which I have seen play out time and again over many decades. And one sector at the top of my list of potential outperformers is energy.

In October, for the first time in nearly two decades, the US produced more crude oil than it imported. That will be the lowest amount of imported oil since 1985.

And within the next ten years, the US will become the world's largest oil producer. This is truly a great American success story that's still unfolding, because the domestic energy boom is just getting started.

So why are energy stocks underperforming? In what seems like a glaring disconnect to the booming domestic energy business, energy stocks have been lagging the broader market, not only in 2013, but for the past several years.

Concerns about a slow-growth global economy and falling prices for oil, and especially natural gas, have weighed on energy-sector performance. But this short-term underperformance is creating a great long-term buying opportunity in a key cyclical sector, which looks extremely undervalued today.

The S&P Energy Index has a P/E ratio of just 14.2, a discount to a P/E of 16.8 for the S&P 500 (SPX). Also based on price-to-book value, the energy sector trades at a discount of nearly 20% from its average valuation over the past 30 years, implying significant upside potential.

Energy stock valuations already reflect slowing global growth and the recent decline in oil prices. Any positive surprises in the economic data next year, say, faster-than-anticipated growth in the US or emerging markets, could pay off in spades with an upside reversal in energy-sector performance.

There are many ways to play the sector, including dozens of ETFs and hundreds of individual stocks, large and small.

The big E&P (exploration and production) and major integrated oil stocks see profits rise and fall with the price of crude. The iShares US Oil & Gas Exploration & Production ETF (IEO) is one way to play this part of the oil patch.

Meanwhile, companies that provide drilling rigs, equipment, and oil-field services can, at times, be a less-volatile play on a bounce in energy.

Energy-service stocks certainly won't be immune if oil and gas prices continue to tumble, mind you, but their longer-term contracts can provide these stocks with a steadier revenue stream and more stable profits.

One ETF that fits the bill here is the SPDR S&P Oil & Gas Equipment & Services ETF (XES).

Energy stocks have lagged the overall market for the past few years and many oil and gas stocks are now undervalued relative to the S&P 500, which is getting pricier as stocks advance.

An upturn in global growth next year makes this sector a great candidate for mean-reversion, as energy stocks move from near-worst to first in the performance derby.

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