XLE: Second Level of Thinking (NYSEARCA:XLE)

Renowned investor Howard Marks, in a September 2015 memo titled “It’s Not Easy,” discussed the concept of “Second Level Thinking.” This is a crucial concept that any investor who aspires to achieve superior performance must understand. This article is about why I think Energy Select Sector SPDR Fund ETF (NYSEARCA:XLE) is a purchase that uses Second Level Thinking.

Marks introduces the concept thus:

Remember, your goal in investing is not to achieve average returns; you want to do better than average. Thus, your thinking must be better than that of others – both stronger and at a higher level. Because other investors may be smart, knowledgeable, and highly computerized, you need to find an advantage they don’t have. You have to think of something they haven’t thought of, see things they miss, or bring a perspective they don’t possess. You have to react differently and behave differently. In short, being right can be a necessity condition for investment success, but it will not be sufficient. You have to be more right than others…which by definition means your thinking has to be different.

The note discusses several examples of second-level thinking. The concept is slightly counterintuitive, but essentially it’s about finding the side effect or second-order effect that the market might not fully appreciate.

As I write this analysis, the market is awaiting Nvidia’s second quarter earnings, and I’m sure it will act as a wake-up call for the entire group of AI boom stocks. To me, it’s inevitable that AI will become more important, but clearly this is top-level thinking. Everyone knows this, and the market has set this price. There are a lot of good companies in this space, but I don’t know if they are good investments.

What I do know is that AI requires data centers, and data centers require energy. But the market has picked up that theme already this year, with stocks like Constellation Energy ( CEG ) and Vistra ( VST ) up 87% and 187%, respectively, over the past year.

In Europe, the Russia Ukraine war has been good for defense stocks, again, unless you have predicted war or the duration of the war is more than a few weeks, buying arms manufacturers would be top-tier thinking. Energy prices skyrocketed in 2022 and have adjusted over the past two years as Russian natural gas has had to be replaced by other sources. European energy companies had a great 2023, but things are starting to normalize.

My second level thinking is that at the intersection of the AI ​​boom and European avoidance of Russian oil and gas is the US energy sector.

An interesting article worth reading in Seeking Alpha on Dominion Energy (D) reads “Data center energy demand is growing rapidly, with projections to double by 2030.” I don’t agree. Many U.S. utilities will benefit from increased electricity demand. But who will provide these utilities?

While renewables have grown in share of energy production, natural gas has grown more rapidly.

Also, with the situation in Russia reordering global oil and gas supplies, the US has become the world’s largest exporter of liquefied natural gas.

And with the Federal Reserve likely to start cutting interest rates, the American consumer will get some relief, so I would expect US gasoline demand to increase.

How to play the increase in energy demand, then?

Unlike many utility companies, the operations of power companies are largely unregulated.

The Energy Select Sector SPDR Fund I do not believe reflects the improved outlook for energy demand and the ability of US industry to provide supply. XLE trades at a P/E of 12.9 and a price to cash flow of 7.4. Importantly, it gives you exposure to the 22 energy stocks in the S&P 500. Alpha Search rates the ETF with an A for Expense Ratio that is just 0.09% and an A+ for Bid/Ask % Spread. XLE has a fund distribution yield (sum of distributions over the past 365 days divided by net asset value per share, expressed as a percentage) of 3.28%.

Holdings

For me, what is very important is the portfolio of holdings.

The largest exposure is Integrated Oil and Gas at 43.3%, which is in Exxon Mobil (XOM), Chevron (CVX) and Occidental Petroleum (OXY). Warren Buffett owns CVX and OXY, and Exxon has the largest scale. While these three massive companies are diversified into various oil and gas businesses, each has low-carbon or new energy divisions to look to the long-term future. They are also global companies, giving XLE some diversification away from purely American oil and gas operations.

Next is Oil and Gas Exploration and Production which holds 21.4% of the fund. It is divided into nine companies, although Hess ( HES ) and Marathon Oil ( MRO ) will exit the index when their acquisitions by Chevron and ConocoPhillips ( COP ) are completed, respectively. Some of these E&P companies are oil-focused, others are natural gas-focused, and some have a split between the two.

The next sector by weight is oil and gas storage and transportation, with 13.3% of the fund. The four companies ONEOK ( OKE ), Williams ( WMB ), Targa Resources ( TRGP ), and Kinder Morgan ( KMI ) own and operate the pipelines and storage tanks vital to the movement of oil and gas across the U.S. and to export hubs. These companies collect mostly flat fees and each has capital spending plans to capture expected growth in US oil and gas production in the coming years. Storage and transportation are key assets for traders, so when commodity prices are volatile, more dislocations are created in the market and pipeline and storage assets are in even greater demand. This sector therefore benefits from increasing production, but also from volatile markets. I would also speculate that, with Hess and Marathon Oil likely to drop out of the index, whichever could be replaced in the S&P 500 Energy Sector Index, LNG exporter Cheniere Energy (LNG), which is classified as a transportation company and oil and gas storage.

Then we have oil and gas refining and trading at 12.2% of the XLE. Valero Energy ( VLO ), Marathon Petroleum ( MPC ), and Phillips 66 ( PSX ) are predominantly exposed to the refining margin of turning crude oil into refined products such as gasoline and diesel. Each has a growing business in renewable fuels, for example in ethanol, renewable diesel and sustainable aviation fuel. Refining margins often do well when the prices of the two key inputs, crude oil and natural gas, fall, as prices of refined products are often slower to follow crude oil prices.

Finally, we have the oil and gas equipment and services sector, which makes up 9.1% of the XLE. The three companies are globally dominant equipment and services companies: Halliburton (HAL), Schlumberger (SLB), and Baker Hughes (BKR). These stocks are exposed to the capital expenditure plans of the rest of the sector. They are also not the oil services companies of old, as they build businesses around data, AI and digital solutions, carbon capture and storage, and have important roles to play in the engineering needed to decarbonize the energy sector. Each of these companies also has large presences in the Middle East, giving them a very long track to earnings from traditional oil and gas production. As reserves for production duration decline in Western oil and gas companies as some products seek to minimize the risk of “failed assets”, the Middle East as the “last man standing” in oil production given its profile of the lowest cost of production, allows Halliburton, Schlumberger and Baker to have visibility into legacy business earnings long into the future.

risks

An energy company, by its very nature, is cyclical. Therefore, balance sheet strength is important to withstand any downturn. We want to capture the positive side of energy demand and supply growth, but we also want some level of protection against damage. The diversified nature of the fund gives us exposure to five different sectors of the energy industry, but more importantly, we calculated the fund’s weighted average Altman Z score by taking each stock’s individual weight and multiplying by its Altman Z score. The weighted average of the fund is 3.28. This simple weighted average obviously ignores the diversification of any portfolio effect, but on its own, the 3.28 puts XLE well within the Altman Z Score’s safe zone of financial stability.

Clearly, I am bullish on natural gas. While this is a similar view to industry experts such as Goldman Sachs Research’s Michele Della Vigna, I don’t think it has enough coverage relative to AI obsession or, say, Federal Reserve monitoring. It would be first-rate thinking to say that interest rates are falling; therefore, real estate should rise. But how many investors are thinking about lower financing costs for capital projects in the energy sector?

But what about oil, given that XLE has a large exposure to oil production and prices. For oil, OPEC’s view is critical. Another article on Seeking Alpha covered this topic very well recently, saying that “Speculation suggests that if OPEC+ extends production cuts in Q1 2025, coupled with geopolitical events, oil prices could see a significant rally.” Production cuts at OPEC would mean more market share for US producers.

Downside risks to the sector could come from increased regulation from a potential Harris administration, limiting project expansion, but the upside is that the Trump administration has a “drill baby, drill” attitude. Also, the fund has about a 40% stake in just two companies, Exxon Mobil and Chevron, so a problem with either of those two companies could hurt XLE’s performance.

Conclusion

Owning XLE provides investors with energy and optionality in terms of price, supply and demand, as well as hedging against inflation with rising oil prices. By investing across the industry, you reap returns across the value chain rather than betting on any one segment of it. XLE’s safe weighted average Altman Z score means that companies generally have strong financial positions, which will be important to fund growth capital expenditures and shareholder returns.

I don’t feel like the AI/data center boom has been reflected in the energy sector as well as the information technology sector or even the performance of some Independent Power Producers.

The fund has a reasonable valuation and low transaction costs.