FENY - FENY: Energy Sector No Longer Attractive At Current Bond Yields

Summary

• US Energy stocks appear cheap on a trailing basis but rising capex spending and falling oil prices suggest earnings and free cash flows will fall sharply over the coming months.
• The Fidelity MSCI Energy Index ETF yields just 3.4%, while the forward yield is 3.2%, having fallen from over 15% in 2020.
• Considering the yields now on offer on US Treasuries, the case for owning energy stocks is not compelling.

US energy stocks have had a tremendous run over the past few years, but with oil prices down almost 40% from their peak, continued gains in energy stocks will be hard to come by unless we see a recovery in oil prices. The Fidelity MSCI Energy Index ETF (FENY) yields just 3.4%, with the dividend yield having fallen from over 15% in 2020. While we should still expect to see the ETF outperform the broader US market, outperformance is likely to result from US equity weakness rather than further energy sector gains. Considering the yields now on offer on US Treasuries, the case for owning energy stocks is not compelling.

The FENY ETF

The FENY seeks to provide investment returns that correspond, before fees and expenses, generally to the performance of the MSCI USA IMI Energy Index. The fund tracks the same index as the Vanguard Energy ETF ( VDE ), and therefore has similar exposure to the underlying companies. Exxon and Chevron dominate the ETF with weightings of 22% and 15% respectively, which is lower than the Energy Select Sector SPDR Fund ( XLE ), where the two oil giants have a combined 42% weighting. The FENY charges an expense fee of just 0.08%, which is slightly lower than the VDE and XLE's 0.1%.

Earnings And Free Cash Flows To Follow Oil Prices Lower

On a trailing basis, the FENY remains extremely cheap relative to its own past. The price-to-earnings ratio sits at just 7.6x while the price-to-free cash flow ratio is 7.9x. However, trailing earnings reflect a combination of high oil prices and low capital expenditure, which are both now heading in the wrong direction. Oil prices have since fallen sharply from their peak, while capital expenditure, which hit a record low share of sales last year, has begun to pick up.

These headwinds are reflected in forward valuation ratios. The forward price-to-earnings ratio sits at 9.7x, while the forward price-to-free cash flow ratio sits at 10.2x. These figures, while still low from a historical perspective, face further upside from a further increase in capex costs. Bloomberg estimates for the coming 12 months put capex at just 7% of sales, which is still significantly below its long-term average of over 10%.

Dividend Yield No Longer Attractive In Context Of High Bond Yields

Rising capex costs and falling sales explain why, despite an extremely high trailing free cash flow yield, the MSCI USA Energy index pays a relatively low dividend yield of 3.9%. Furthermore, the forward dividend yield is even lower at just 3.2% as analysts anticipate a ~20% decline in payouts over the coming year. To be clear, this is still considerably higher than the yield on offer on the SPX, and I continue to expect long-term outperformance for the energy sector relative to the overall market. However, this says more about the bearish outlook for the SPX rather than the bullish outlook for the FENY.

Considering that investors can receive a yield of almost 5% on 2-year US Treasuries, a 3.2% dividend yield is not particularly attractive, especially when considering the significantly higher degree of volatility. The spread between the forward yield on the MSCI USA Energy index and 2-year UST yields is now -1.7%, which is the lowest it has been since the start of 2008. In the 15 years since the start of 2008, the MSCI USA Energy index has outperformed by just over 1% per year, while seeing three separate relative declines of around 50%.

Summary

The FENY still appears cheap on a trailing basis but rising capex spending and falling oil prices suggests earnings and free cash flows will fall sharply over the next 12 months. The relatively low forward dividend yield of just 3.2%, having fallen from over 15% in 2020, reflects expectations of continued rising capex costs. While the forward yield is still significantly higher than that of the SPX, it is no longer attractive compared to the yield on US Treasuries.

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