2023-10-30 15:55:22 ET
Summary
- XLE is heavily concentrated in Exxon and Chevron, making up 40% of the portfolio.
- EBITDA growth is expected to be slow at 3% due to weak production expansion and flat oil prices.
- M&A potential for the ETF is limited, with a weighted upside potential of 16% based on potential targets.
Summary
Energy Select Sector SPDR® Fund ETF (XLE) is the go-to oil sector ETF with US$38bn in AUM, more than 4x larger than the next ETF in this sector. It is also very concentrated with just 22 holdings and the two majors, Exxon Mobil (XOM) and Chevron (CVX), make up 40% of the portfolio. Thus, I rate XLE a HOLD given slow growth and high valuations at Exxon and Chevron plus the fund may miss out on a potential M&A wave, in my view.
The ETF has performed nearly identical to the SP500 energy index but far below the oil price over its more than 20-year history.
XLE vs SP Energy Index & Oil Prices (Created by author with data from Capital IQ)
I recently completed an analysis of two other oil sector ETFs that provided an interesting comparision. It appears the XLE has a slightly greater consensus upside but a more expensive valuation and limited M&A upside potential.
XOP ETF: M&A Exposure With Potential For 100% Upside
FENY ETF: U.S. Oil Sector Deleveraging Vs. Growth
XLE Comps (Created by author with data from Capital IQ)
Portfolio Concentration
I conducted a bottom-up analysis using consensus estimates to calculate potential upside, dividend yield, EBITDA growth, deleveraging and M&A potential. The table below highlights the portfolio concentration or lack of diversification and the potential upside based on consensus price targets. With a heavy concentration in Exxon and Chevron, it's difficult to deviate far from their influence. The oil service sector appears to warrant more attention and I do not see M&A targets priced near the Hess Corporation (HES) or Pioneer Natural Resources Company (PXD) levels yet.
XLE Consensus Price Target (Created by author with data from Capital IQ)
Slow EBITDA Growth
I calculated that the ETF may grow EBITDA by 3% in the YE24-25 period, based on consensus estimates. This low growth is driven by weak production expansion and most likely flat oil prices. Oil & Gas producers are implementing a capital discipline strategy, limiting expansion capex and focusing on generating free cashflow to reduce debt and pay out dividends. Consensus may also be influenced by flat or lower oil price inputs since many analysts rarely deviate from the oil price futures curve or in-house research inputs.
Key portfolio heavyweights, Exxon, Chevron and ConocoPhillips (COP) have near-stagnant EBITDA growth according to consensus estimates, this may challenge valuations and impact the ETF's performance.
XLE Consensus EBITDA Growth (Created by author with data from Capital IQ)
M&A Potential Limited
With the HESS and Pioneer acquisitions, investors may be wondering who is next and can this ETF benefit from the M&A wave. I conducted a sensitivity analysis and priced the shares of potential targets at the average EV/EBITDA multiple implied by these two deals. I adjusted this for the acquirers and those stocks that are not oil & gas producers such as refining, service, and pipeline operators. This generated a weighted upside potential of 16% for the ETF.
Keep in mind that this a food for thought exercise, actual M&A and valuations will vary depending on potential synergies with the buyer as well as oil reserve life. EOG ( EOG ), Valero ( VLO ), Devon ( DVN ) and Warren´s Occidental ( OXY ) look to warrant attention from the market.
XLE M&A Scenario (Created by author with data from Capital IQ)
Deleveraging
As the sector executes its capital discipline strategy, in the face of reduced demand long term due to decarbonization and energy transformation policies, it should reduce debt as highlighted by consensus ND (net debt) estimates. The ETF may see a sustained decline in ND through 2025 of 14%, which helps but does not offset the low EBITDA growth. The sector already has low leverage at .8x ND/EBITDA.
The major portfolio weights, Exxon and Chevron, have almost no net debt which limits the deleveraging impact on the ETF's valuation.
XLE Consensus Net Debt Growth (Created by author with data from Capital IQ)
Total Return
I calculated a total return potential for the ETF through 2025 of 26%, in line with Exxon and Chevron estimates. I used the YE24 consensus price target to derive the implied EV/EBITDA target multiple that I applied to YE25 EBITDA and ND to generate the YE25 price target. As can be seen, the bulk of potential return is in YE24 of 20%.
Outliers are oil service stocks such as Schlumberger ( SLB ) and natural gas producer EQT ( EQT ) with over 40% total returns. The market may favor stocks with higher and more consistent growth, which may hinder XLE's performance due to its concentration in low-growth stocks.
XLE Consensus Total Return (Created by author with data from Capital IQ)
Conclusion
XLE is a hold. The portfolio concentration, low EBITDA growth, and poor M&A optionality are not offset by the capital discipline strategy of deleveraging and dividend payouts. At the same time, oil price visibility has rarely been clear, making commodity investing a higher risk-reward endeavor.
For further details see:
XLE: Bigger Is Not Always Better