Description

Cliff notes:  Buy XLE.  I think Energy will be the best performing sector in the S&P 500 this year with 50%+ upside to current levels.

A good friend of mine that’s the global head of trading at a large bank just sent me a text.  “There isn’t enough market cap to absorb these reopening trades allocation away from tech.  You can lift a million boats with a 1% allocation away from AAPL.”

Not the most eloquent text, but his comment got my wheels turning.  We are all familiar with Black Monday – the famous market crash in October 1987.  Well my energy portfolio experienced “Vaccine Monday” on November 9, 2020.  Coming into November, I was skeptical of a massive blue sweep / reflation trade, and after the election I felt vindicated as the blue sweep appeared to be a dud.  At the same time, I saw spiking COVID case counts and a wave of new lockdowns.  I was like, “cool, energy is so screwed, let’s press some shorts”.  Then Vaccine Monday hit me like a sledge hammer – XLE up 14% in a single day.  Vaccine Monday proved that Energy was one of the greatest reflation sector trades.  It’s no bitcoin, but if I pitch that you guys will send me to the mental asylum!

Obviously the XLE has a good start to the year in 2021, but I would like to make a few observations:

• Oil just got back to pre-COVID levels but the XLE is still (27%) down from Jan 1, 2020

• Oil has been a major commodity laggard relative to most commodities… For example, look at Natural Gas, Silver, Copper, Soybeans, Corn, etc. (all are up 50%-ish over the last year).  This is beyond the scope of this write-up, but I happen to think we are in the early innings of a new commodity cycle.... the fiscal and monetary stimulus is too much.

• The combined market cap of all the components of the XLE is $856 billion – that’s about 2.5% of the S&P500.  To further frame - that’s around the market cap of Tesla.  To put this further in perspective, Energy was around 12% of S&P500 in 2012.

• What a difference 9 months makes.  In March 2020, OPEC went full retard on oil, because Saudis and Putin couldn’t agree on cuts….  two months later we saw WTI April 2020 contact trade to negative $40.  Then in December 2020 we see Saudis magnanimously cut, unilaterally!

• Biden inaugurated - day 2 he kills Keystone XL.  Not a week into his presidency he starts talking about a fed land ban.  So this whole narrative that US Shale is a swing producer is tough to defend in this political climate

• And dare I suggest that most US oil companies are no longer goal seeking to max production growth… and trying instead to actually produce some positive FCF

• Iran deal coming back?  Not so soon.  Biden’s latest demand is that the Iranians need to get back into compliance with old deal before he is ready to re-engage

• Continued vaccine roll out will steadily improve mobility in our society (driving, flying, etc.)  throughout 2021.  Just over the past couple days, we learned vaccine cadence is likely to accelerate over the coming months.  This mean oil demand will steadily increase throughout the year

• Fair warning that XLE is 25% XOM and 21% CVX.  Last time XOM was written up on VIC as long was 2010, however it was written up as a short in 2016.  CVX has never been written up on VIC

Small digression – I spent some time trying to figure out how much market cap in the US is growth vs. value.  Short answer is I didn’t figure out a good answer.  If anyone has a precise answer to this – please share in the comments.  I looked at Russell 1000 Growth vs. Value and found some stats:

• R100 Growth has 453 names, weighted average market cap of 736 billion and median market cap of 16.5 billion

• R1000 Value has 850 names, weighted average market cap of 133 billion and median market cap of 11.3 billion

Problem is that I don’t have simple average to back into total market cap for each index… and R100 value has nearly 2x as many names.  Would be nice to now the answer, but my swag is that growth stocks probably account for around 2/3 (or more) of S&P500 in market cap. 

Looking at the S&P500, the top 6 stocks alone account for 23% of market cap or 8 trillion.  So if everyone decided to trim 10% of their Apple, Microsoft, Amazon, Facebook, Tesla, Google, to put into reflation trades, that’s nearly the entire market cap of the XLE.  So I think my buddy is spot on.  There isn’t enough market cap to  re-allocate capital into the higher beta reflation trades (like energy). 

So to summarize: energy stocks have lagged the oil commodity.  The oil commodity has lagged the broader commodity complex.  Oil demand will accelerate and massive crude supply unlikely to materialize anytime soon.  Fund flow math suggests that any meaningful re-allocation of growth capital will have an outsized impact on energy stocks.   Thus, XLE is a good risk adjusted reflation trade. 

Risks:

• Biden bans US crude exports in order to kill US shale.  WTI / Brent spread blows out.  Refiners rip, E&P’s selling WTI-linked get crushed 

• Biden falls in love with Iran

• COVID-21 pops up and world shuts down again

Catalyst

• Reflation trade

• Rotation from Growth to Value

• Vaccine roll-out / gradual return to pre-COVID life