Correlation Analysis: Oil Prices & Energy Stocks

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Correlation Analysis: Oil Prices & Energy Stocks

In Sunday night’s report we wrote, “Do not underweight energy stocks”. After a decade of underperformance the sector is down to trace element status (3% – 7%) in major US/global equity indices. Worries over depressed energy commodity prices and rising concerns that oil fields are “stranded assets” are the root causes of that. But increasing Middle East tensions now mean it is unwise to have anything less than market weight exposure.

Today we will extend the conversation by answering the question “how closely do US energy stocks move with the price of oil?” Our approach takes the S&P 500 Energy sector (tracked by the XLE exchange traded fund) and compares its daily return to the daily change in the price of near-dated West Texas Intermediate crude oil contracts.

Looking at the 90-day price change correlation between large cap US energy stocks and crude, we see the following:

  • Since 1999 the average correlation between the two is 0.49, for an r-squared of 24%. Yes, that’s lower than we thought it would be but we’ll explain why it makes sense shortly.
  • Over the last 90 days, the correlation between crude and energy stocks is slightly higher at 0.55 (r-squared of 30%). This is, however, well within 1 standard deviation of the distribution (0.18).
  • Ironically, the lowest correlations (-0.09) occurred in March-June 2003, at the start of the US coalition invasion of Iraq. Crude prices fell by 16.5%, but the S&P 500 Energy sector rose by 8.9%.
  • The highest correlation (+0.82) occurred in June-August 2009 as global markets were recovering from the 2008 Financial Crisis. Neither oil nor energy stocks moved very much over this period, but their day-to-day price action was in virtual lock step.

We see 3 investment implications from this analysis:

#1: Energy stocks are, at best, an imperfect hedge against rising oil prices. That is because their valuations are as much tied to stock market performance as to the price of crude. Yes, they may outperform the broad market (hence our recommendation to even-weight the group). But don’t expect to see Energy stocks rise in absolute value terms when oil prices move higher. It just doesn’t work that way.

#2: This means one must look further afield for defensive plays to effectively inoculate a portfolio from an oil shock. The logical choices are Utilities (3.0% yield), Consumer Staples (2.6%), and Real Estate (3.1%), in that order. Worth noting: the large cap Energy sector’s dividend yield of 2.8% is actually higher than Staples’ 2.6%. Still, we see little evidence that investors believe this payout is as sustainable as more traditionally defensive sectors.

#3: In the end, the only real hedge against an oil shock in a long-only portfolio is cash and longer dated high quality sovereign debt. As we have mentioned in recent notes, global equity valuations carry little event risk just now. And even though a prolonged period of high oil prices will carry the specter of inflationary pressures, the market’s initial response will be to assume a recession is at hand. As we saw last year, this will help rally long dated Treasuries, German bunds, and other developed economy sovereign debt.

Summing up: while we remain bullish and most certainly do not expect a disruptive Middle East military conflict, it always pays to consider one’s options. Energy stocks provide only a limited hedge, better than growthier sectors, but not perfectly correlated exposure to rising commodity prices. Defensive plays will outperform if tensions rise, but they are unlikely to appreciate on an absolute basis. If you believe a military conflict is inevitable, the only certain path to capital preservation is to sell now.