As the S&P 500 continues to notch fresh all-time highs, investors' bullishness on U.S. stocks has ebbed. Stock market valuations look fair at best--and, in some corners, stretched. According to our equity analysts, the S&P 500 looks fairly valued at present, as indicated by our current price/fair value estimate for 
SPDR S&P 500 (SPY), which stands at 0.99.
However, looking one layer deeper reveals a potential opportunity in the U.S. energy sector. In the table below, I've looked at valuations across each of the nine sectors of the S&P 500, as represented by the Select Sector SPDRs that track the relevant sector benchmarks. Based on this snapshot -- which includes our analysts' fair value estimates and current and historical average yields, price/book value ratios and price/earnings ratios -- most sectors appear to be either fairly valued or modestly overvalued at present. However, the late-2014 downdraft in oil prices appears to have created a potential opportunity in the energy sector.
Below, my colleague John Gabriel shines a spotlight on the largest and most-liquid U.S.-traded ETF tracking the sector, Energy Select Sector SPDR (XLE). As always when considering investing in U.S.-dollar instruments, please ensure that currency conversion costs don't take too big a bite out of your returns when measured in Canadian dollars.
Suitability
XLE holds 41 oil and gas and energy-services companies contained in the S&P 500 Index, offering diverse exposure to the various industries that comprise the U.S. energy sector. Integrated oil and gas firms make up the largest portion of the portfolio at 32% of assets, followed by oil and gas exploration and production firms (29%), equipment and services companies (17%), storage and transportation firms (10%), refiners (10%) and coal and consumable fuels companies (1%). Mega- and large-cap stocks make up about 85% of the portfolio, with mid-caps representing the remaining 15% of assets.
As a market-cap-weighted fund, its portfolio is fairly top-heavy. Vertically integrated giants Exxon Mobil (XOM) and Chevron (CVX) alone make up nearly 30% of XLE's portfolio. While these two firms represent a large chunk of assets, they operate in a diverse set of businesses across the energy complex. Their operations range from exploration and production all the way down to distribution. This helps damp their sensitivity to energy prices but does not eliminate it entirely.
Other segments of the oil patch, such as exploration and production, are much more sensitive to volatile energy prices. Investors should expect the underlying firms' reliance on energy prices to translate into higher volatility for XLE relative to the broader market. Its standard deviation of returns was more than 22% over the past 10 years, compared to 14.7% for the S&P 500. Current turmoil in the Middle East, speculation about production cuts (or lack thereof) by Saudi Arabia and other OPEC members, and surging shale oil volumes out of the United States have all contributed to recent energy price volatility.
Over the years, the diversification potential of XLE seems to have been eroding. Over the past 15 years, XLE has been 64% correlated with the S&P 500. However, over 10- and five-year periods, its correlation to the S&P 500 has increased to 71% and 84%, respectively. Still, the fund remains an effective tool for investors seeking to have an overweighting to the energy sector within a broadly diversified portfolio. The energy sector currently makes up about 9% of the S&P 500.
Fundamental view
Integrated oil and gas companies have operations that span the full energy value chain. They explore for and produce oil and gas, transport it, refine or process it, and sell it to end users. This model has historically provided firms like Exxon Mobil and Chevron with competitive advantages, as these firms are able to gain much tighter control over the production and sale of oil and gas. And they get to keep profits they would otherwise have paid out to middlemen in the form of economic rents.
In an attempt to secure long-term access to large-scale resources, the large integrated firms are competing for huge new projects and increasingly partnering with foreign national oil companies seeking to exploit government-owned resources. In a world of diminishing investable resources, securing such partnerships is important to help drive growth. This puts added emphasis on firms' technical expertise, ability to execute on time and budget, safety record and cost of capital.
Exploration and production companies concentrate their efforts almost exclusively on exploring for, acquiring and producing oil and natural gas. These firms face myriad risks, including commodity price volatility, exploration risks, operational risks and political and regulatory scrutiny. Given the intense competition in this segment as well as the difficulty individual firms face in establishing competitive advantages, getting diversified exposure through an ETF like XLE may be appropriate for most investors.
Equipment and services firms provide the expertise necessary to improve the economics and boost productivity of oil and gas wells. The industry does serve U.S. independent oil and gas firms, but its largest customers tend to be the major international and government-owned oil companies. Demand for services in any given year tends to wax and wane, depending on customer expectations around commodity prices, particularly in North America, where contracts are usually very short.
The cyclical nature of the industry can obscure some of the positive long-term trends, which remain favourable. Oil, in particular, is becoming harder to find and extract. Global oil production has been stagnant since 2005, even after a trillion-dollar investment by the oil and gas industry. The number (and size) of oil discoveries made has been declining for decades. Oil-services firms' expertise is growing increasingly more valuable as the industry seeks to explore and extract oil from ever-more-challenging frontiers in new deep-water and even Arctic efforts. Large efforts are also under way to boost recovery rates from old fields.
