The new type of coronavirus that recently appeared in Wuhan, China has negatively impacted investor sentiment as efforts to stop it from spreading threaten to reduce traveling and manufacturing activity in the country.
The virus, dubbed 2019-nCoV, is part of a family of respiratory diseases that ranges in severity from minor sniffles to the potentially life-threatening MERS and SARS. Scientists are still unclear on exactly how this new strain stacks up against its relatives, while business analysts struggle to predict what impact it will have on markets.
Overall, the S&P 500 was down about 1.4% in early afternoon trading on Monday, showing that investors in U.S. companies are worried that the virus might negatively impact the U.S. economy as well. The energy sector showed sharper declines than the overall market, with Brent crude falling 3% and the Energy Select Sector SPDR Fund (XLE, Financial) Exchange-Traded Fund (shown below) declining 2.78%.
Among individual S&P 500 energy stocks, Halliburton Co. (HAL, Financial) lost 5.69%, Schlumberger Ltd. (SLB, Financial) lost 5.26%, Marathon Oil Corp. (MRO, Financial) lost 2.77% and Exxon Mobil Corp. (XOM, Financial) lost 2.19%.
Energy versus the market
Why does the new coronavirus seem to be affecting the energy sector worse than the overall U.S. market?
Perhaps part of the reason is due to an anticipated slowdown in spending on travel for the Lunar New Year, which may cause a decrease in the amount of fuel purchased by airlines.
The threats that the disease poses to Chinese manufacturing may also come into play here, as some companies are suspending parts of their operations. For example, automakers Nissan Motor Co. (TSE:7201) and Peugeot SA (XPAR:UG) said they were preparing to pull non-Chinese staff out of plants in areas of China that had been hit by the virus. The Foxconn (TPE:2354) factory in Suzhou has postponed the return to work of millions of migrant laborers.
However, there may be other reasons for the energy sector’s high volatility. Over the past year through Jan. 27, the 28 energy stocks in the S&P 500 have declined 6.43%, while the broader index has returned 22.77%. The underperformance has caused some analysts to speculate that it may be best to hold off on buying energy stocks for the time being, even if it may look tempting to jump in after a negative news event causes significant drops in stock prices.
Growing inventories
The size of the energy production sector makes it a slow-moving one, with little ability to fine-tune production to accurately meet demand. In mid-2018, the U.S. became the largest producer of oil in the world, but that doesn’t mean OPEC’s production declined enough to counteract it. In 2018 alone, U.S. petroleum production increased by 16% while its natural gas production increased by 12%. OPEC’s production declined 1.3% the same year. Overall, world oil production rose 1.6% in 2018 while demand rose by 1.5%. Global crude oil reserves increased by approximately 0.4%.
With supply growing faster than demand, oil prices are likely to continue facing downward pressure. Moreover, most of the growth in the world’s oil production has come from the U.S. The U.S. dollar has strengthened against many foreign currencies in recent years, making U.S. oil a less attractive buy for foreign countries.
The shale boom that sent the S&P 500 Energy ETF soaring more than 80% in the first half of the decade appears to have come to an end – not for the physical market, but for the stock market.
Poor risk-reward
“It’s a bearish trend and a poor risk-reward,” Oppenheimer’s head of technical analysis, Ari Wald, said on CNBC. “The sector has just not been rewarded when oil rises to the same degree it’s been slammed when oil falls.”
As you can see in the below chart of the Energy Select Sector SPDR Fund ETF over the past decade, the prices of energy stocks have had their ups and downs over the years, but they have ultimately hovered around a central line. If the losses from a share price decline of 50% can only be recouped by an increase of 100%, then a price that has been fluctuating around a central line in recent history does not provide a promising risk-reward ratio.
A look at financials
In terms of profitability, the energy sector has seen its net income drop in the years since 2012, as you can see in the chart below.
Many energy stock prices never reached the valuation of their earnings during their highs and have since transitioned to trading at prices higher than the valuation of their current earnings. Once example is Exxon Mobil, as represented by the Peter Lynch chart below.
In addition, most of the energy stocks in the S&P 500 are trading below their historical cash-debt ratios, indicating that the companies are taking on more debt. Below are the historical cash-debt charts for the following companies: Exxon Mobil, Chevron (CVX, Financial), ConocoPhillips (COP, Financial) and Schlumberger.
Waiting for a positive sign
According to Statista, global demand for crude oil is expected to increase another 1.3% in 2020. If global oil production continues its current growth rate of 1.6% per year, we may see the oversupply problem worsen, which would not be a good sign for the overall profitability of the oil producers on the S&P 500.
While the new coronavirus may seem like a good opportunity to buy energy stocks, the fact that the news had more of an impact on this sector than most others is a red flag. The energy sector is a slow-moving one, and the only factors that can move it in the long term are also slow-moving, such as global production and the development of new drilling techniques. Before investing in energy, it may be best to wait for a positive sign rather than waiting for the rebound of a negative one.
Disclosure: Author owns no shares in any of the stocks mentioned. The mention of stocks in this article does not at any point constitute an investment recommendation. Investors should always conduct their own careful analysis or consult registered investment advisors before taking action in the stock market.
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