VDE - VDE: After The Pullback Energy Is A No-Brainer (Rating Upgrade)

2023-10-30 10:21:49 ET

Summary

• The article evaluates the Vanguard Energy ETF as an investment option at its current market price.
• The current conflict in the Middle East should help sustain higher energy prices, supporting the companies in VDE's portfolio.
• Future oil production remains challenged by a declining rig count in the US and the willingness of OPEC+ to continue output cuts. This is a positive for Energy investors.

Main Thesis & Background

The purpose of this article is to evaluate the Vanguard Energy ETF ( VDE ) as an investment option at its current market price. This is a passively managed sector fund with an objective to "track the performance of a benchmark index that measures the investment return of stocks in the energy sector."

I have long been a proponent of holding the Energy sector (whether via VDE or some other avenue) in my portfolio - and this is something I suggested to my followers multiple times over the years. While I believe in this sector long-term and in most environments, it isn't always a buy. This was true when I last covered this ETF back in Sept . I saw strong gains in rapid succession - and that usually makes me cautious. In hindsight, that caution has been vindicated:

As you can see, VDE has seen a pullback, but it is lower by comparison to the broader S&P 500. With this reality, I thought it was timely to consider if VDE offered some value here. Considering both the recent drop and the rise of military conflict in a key oil-producing region of the world, I do believe VDE represents an interesting opportunity. As a result, I am upgrading my rating to "buy" for this fund. I will explain the reasons for this decision in detail below.

The Middle-East Is A Wildcard

The most important attribute for oil and energy in my mind right now is the current military conflict between Israel and Hamas. As readers know, oil prices spiked in the immediate reaction to this conflict. But, throughout October, prices have moderated. While they remain relatively elevated, they have pulled off their highs noticeably. This poses the question - is the opportunity to profit off high oil prices passed, or is there still room to see them go higher from here?

The answer, of course, is speculative at this point and I would encourage all my followers to consider their own outlook. But one point would be hard to debate: that the ultimate impact of this war on oil prices, while uncertain, will almost certainly rise if there is an expansion or escalation in this conflict.

That could take multiple forms. Whether it means more nations get involved - such as the US or Iran, if Israel expands its ground operations in to additional territories, or if oil producers weaponize their oil production to get concessions from the US and the West to stay out of the conflict. All of these outcomes have a very realistic chance of sending oil prices soaring. If so, that would provide a major boost to energy companies that comprise VDE.

Of course, the opposite take should be considered as this poses a risk to investors in this ETF. If the conflict were to resolve quickly (which I do not anticipate) and/or it remains isolated between Israel and Hamas, then the potential for soaring energy prices are probably not going to materialize. The impact will be moderate, as it has been in the past week or so.

If that is the resolution here, then the continued rise in oil prices - and their sustainability - are not going to be reminiscent of the 1970's - 1980's:

My conclusion here is that investors need to be aware of the heightened risks the current geopolitical environment poses. I see it as an opportunity personally, hence my bullish outlook. But the potential for disproportionate losses is present as well, and I would urge my followers to consider these carefully before buying in too deeply if they choose to do so.

US Rig Count Supports Higher Prices

This is another key driver that is supportive of higher oil prices, and it gets more excited than geopolitical risks. That is because those events can often be fleeting and volatile, resulting in temporary profits but longer term uncertainty. By contrast, structural changes in the Energy sector that deliver long-term benefits are truly what investors should want to see.

So, what are some of these structural changes? One is that the rig count in the US - a major oil/energy producer - has been declining recently. In fact, the total U.S. rig count is down over 20% from the peak in December last year. This has coincided with a rise in WTI crude prices, which tend to be inversely correlated over time, as shown below:

This has been driven by a number of factors. One, in this political environment here in the US, some producers are reluctant to invest much in more production facilities because of uncertainty. This uncertainty - regarding government support and/or new regulations - makes companies hesitant to commit to longer term investments because they do not know if they will pay off down the road. Further, in a structural shift, larger drillers that have bought out smaller firms are beginning to retire the legacy rigs, rather than using them to continue or expand operations.

The net result is fewer rigs and the potential for tighter US supply in the years ahead. This is a fundamental shift in policy from the production majors in this sector who used to focus more on volume. Now they are more disciplined and focused on keeping prices sustainably higher to drive more consistent returns. From a consumer perspective, this poses a challenge. But as an investor, this opens up an opportunity to be long this sector for the foreseeable future. This alone helps to support the "buy" rating on funds such as VDE.

Supply Expected To Be Tight Outside US As Well

Expanding on the above discussion, it isn't just the US rig count that is concerning for the global oil demand-supply imbalance. As readers are surely aware, the US is just one piece of the puzzle. OPEC+ plays a major role, as do other countries on the demand side, notably China and India. So while US production has actually remained high (despite the movement on domestic rigs), OPEC+ (primarily Saudi Arabia) and Russia have been voluntarily extending supply cuts that were initially expected to be temporary.

The net result is that global demand is anticipated to outpace supply for the rest of 2023, with my prediction this will continue in to early 2024 too:

This is central to why I like buying Energy - and VDE by extension - on any sector pullback (such as right now). The marketplace simply does not have enough energy inputs to meet demand, so prices are going to have to rise. This plays right into the hands of the companies in VDE's portfolio.

US Short On Options

The next topic for discussion is an unfortunate one. This has to do with the situation the US government finds itself in with respect to keeping energy prices low for US consumers. While the releases from the Strategic Petroleum Reserve ((SPR)) last year were marginally effective, the US doesn't really have this option in its arsenal anymore.

While just one option out of many, this is an important one because it would often make headlines and cause (somewhat fleeting) a moderation in end-user prices (think at the gas pump). However, the SPR has not been replenished after being drawn down last year. Aside from putting the country in a more precarious position, it limits any opportunity to moderate the crude oil market with additional releases in Q4 and next year:

What I am driving at here is that the market is going to be left to its own devices in the short-term. The OPEC+ conglomerate is committed to keeping prices high and the US government has very few options to fight higher domestic prices at the moment. The SPR is at levels that are precarious, so further releases will be limited in their impact and will be irresponsible right now, in my opinion. All of this adds up to a favorable backdrop for VDE.

A Reminder Of Concentration Risk

My last topic of discussion is to remind readers that VDE remains very top-heavy. This is not inherently "bad", but it is an important consideration because it means that, despite owning 100 companies, investors are very beholden to the fortunes of a handful of names:

Similar to the opening paragraph, this has potential for both rewards and losses. We don't have to look much further back than this past Friday (10/27) when Chevron ( CVX ) reported Q3 earnings. The market wasn't thrilled with the results, and the stock paid the price:

This pressured VDE of course and should be a reminder about the risks facing investors when picking up this fund. If any of the majors in this fund see a bad drop, that is undoubtedly going to result in losses for the fund overall.

Bottom Line

VDE has seen weakness in the near term, but I view that positively as a buying opportunity. Current geo-political risks, continued tight supply, and a favorable backdrop expected in 2024 for the Energy sector all convince me that a bullish review here is the right one. As a result, I am upgrading my rating on this fund to "buy", and I would urge my followers to give the idea some thought going forward.

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