Russ discusses why the energy sector still looks attractive, despite having struggled recently.

Following a stellar start to the year, energy companies have stumbled in recent weeks. Although the U.S. sector is still one of only four that is higher year-to-date, energy stocks have dropped more than 3% during the past month, in the process under-performing the broader market. Bellicose trade rhetoric has not helped, but the main culprit has been the prospect of higher OPEC production and an accompanying 10% drop in the price of crude. That said, while the sector is vulnerable to another big drop in oil, current prices suggest the stocks may be a bargain. Here’s why:

1. Value versus history

At two times trailing price-to-book (P/B) the sector looks cheap relative to its own history. Since 1995 the large cap S&P Energy Sector Index has traded at an average of approximately 2.4 P/B.

2. Value versus broader market

Energy stocks look even cheaper relative to the broader market. The sector currently trades at just 0.57 times the P/B of the S&P 500 (see Chart 1). This compares favorably to the long-term average of 0.82 and the post-crisis average of 0.76. This is one reason energy stocks are currently over-represented in value indexes.

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3. Value versus fundamentals.

U.S. energy companies also appear cheap relative to two key fundamental factors: profitability and the price of oil. The fact that energy companies trade in line with crude should come as no surprise. Historically, investors have been willing to pay a premium, or at least a smaller discount, when the price of oil is high. Since 1995, this relationship has explained approximately 20% of the variation in the relative value of the energy sector. Today, with WTI crude at approximately $65 a barrel, the energy sector looks approximately 20% undervalued versus the broader market. A similar picture emerges when comparing current valuations to profitability. Measured by return-on-equity (ROE), profitability also explains about 20% of the variation in valuations. Based on this metric, energy companies appear about 10% too cheap.