Energy Stock Rally Leads to Hedging as Prices Don't Match Profit

  • Protection costs for SPDR energy ETF highest since January
  • S&P 500 Energy Index has rebounded 13 percent since August low

A quick rebound from a four-year low that sent energy stocks to the highest valuations in the Standard & Poor’s 500 Index has investors jockeying for downside protection.

Implied volatility on an exchange-traded fund tracking energy companies is at its highest in 10 months versus another ETF mirroring the S&P 500, according to data compiled by Bloomberg. The increase signals rising demand for options used to hedge against losses in energy shares that have climbed 14 percent since bottoming out in August.

Energy stocks in the S&P 500 are the third-best performing group in the gauge since the August correction, even with crude oil falling to the lowest level in three months. The share appreciation, combined with the biggest corporate profit contraction since 2009, has sent the sector’s price-to-earnings ratio soaring.

“Valuations are not cheap in this sector and there’s no economic tailwind helping it,” said Alan Gayle, senior strategist for Atlanta-based RidgeWorth Investments, which oversees $40 billion and is underweight energy stocks. “The P/E ratio for the energy group is distorted, while the downtrend in prices remains firmly in place.”

The S&P 500 Energy Index added 0.7 percent at 4 p.m. in New York. The gauge’s forward price-earnings ratio, or its value relative to projected profit for the next 12 months, is 28 times, the most out of any group in the benchmark gauge. This month’s P/Es have been as high as 30.4, about twice the average since the current bull market got started in March 2009, Bloomberg data show.

Saddled with the worst third-quarter earnings in the S&P 500, energy companies are struggling to justify such lofty valuations. Profits contracted 57 percent, almost four times more than for materials, the next-worse performing sector. Analysts see bleaker results for the fourth quarter, forecasting a 66 percent profit drop.

The energy group’s forward P/E ratio “reflects a lingering belief in the market that energy earnings are going to grow significantly next year,” said Gayle. “Investors are willing to pay up for it. But I just don’t see the excess supply overhang in the market that’s driving oil prices lower receding anytime soon.”

One money manager that sees energy shares living up to expectations is Walter Todd of Greenwood Capital Associates LLC. He doesn’t expect oil to slip back below the the level of $38.24 a barrel reached three months ago, which marked its lowest closing price in six and a half years.

“Our view is that the August low will serve as resistance,” said Todd, who oversees about $1.1 billion, including energy shares, as chief investment officer for Greenwood Capital in South Carolina. “There may be short-term pullbacks, but the longer-term trend is higher. We’re not looking for it to snap back to $60, but we think it’s seen the lows.”

Energy companies in the S&P 500 are forecast to see earnings growth of just 1.3 percent in 2016. That pales in comparison to the 7.2 percent profit expansion forecast for the broader benchmark index for the same period.

Elevated hedging premiums for energy stocks can be seen in the six-month implied volatility spread between the Energy Select Sector SPDR Fund and the SPDR S&P 500 ETF Trust. The measure rose to 9.85 on Nov. 13, the highest since Jan. 15, according to Bloomberg data. That’s 44 percent above its one-year average of 6.86, the data show.

To Deutsche Bank AG chief U.S. equity strategist David Bianco, the energy sector’s forward P/E ratio suggests investors see oil prices averaging $65 to $70 a barrel in 2016. However, crude averaged about $50 a barrel this year in New York trading, and next year’s median forecast in a Bloomberg survey is $55.

Energy is one of four areas where Bianco’s recommended weighting is lower than its share of the S&P 500 would indicate. The others are raw-material producers, industrial companies and makers of food beverages, and other consumer staples.

“S&P energy stocks are substantially overvalued relative to current oil prices,” Bianco wrote in a Nov. 16 note to clients. “The S&P should finish the year in black, but there’s more red ahead for energy.”

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