NEW YORK — Forget politics and religion. One of the biggest debates on Wall Street these days is whether oil and energy stocks are toxic or terrific.
Bank of America Merrill Lynch put out a note last week telling clients now is the time to buy. Hedge funds have already pounced. The 50 largest hedge funds bought a lot of energy stocks (e.g. Williams Partners, Energy Transfer Partners and Kinder Morgan) in the first quarter, according to their latest stock disclosures.
In some ways, it looks like a smart move. Oil plunged below $45 a barrel in January. Back then, people couldn’t seem to sell energy stocks fast enough. In recent weeks, oil has staged a mini-rally. Now it’s trading around $60 a barrel.
That’s still far from the glory days of over $100 a barrel that the industry saw as recently as last summer, but for drillers, it’s a lot easier to make a profit when oil is back around the $60 mark. Bank of America thinks “the bottom is well behind us.”
Stay away from oil? But there are still plenty of naysayers. Goldman Sachs just predicted that oil will return to $45 a barrel in the fall. Cheap gas prices should make many Americans happy and help boost the U.S. economy, but they won’t aid corporate energy profits.
Prominent investor Jeffrey Gundlach has gone as far as saying that it “makes no sense” to buy oil or energy stocks now.
“Too many people think it’s cute to make a distressed play on energy,” said Gundlach, founder of DoubleLine Capital, which manages over $63 billion. “Usually the people who buy because they think it’s clever end up selling to other people at a lower price.”
Despite oil prices rallying recently, Bbig oil stocks like Exxon Mobil and Chevron are also struggling — both are down around 6% this year. Even funds that track oil such as the ProShares Ultra Bloomberg Crude Oil are still negative year-to-date.
From Wall Street to Main Street, investors have to decide where they think oil prices are headed: up or down. That’s notoriously difficult.
“It’s our gut that oil prices have found a near-term bottom,” says Dan Greenhaus, chief strategist of BTIG. “But how quickly prices rise — and by extension the stocks — is an open question.”
This week investors will get more expert views as both Exxon and Chevron have their annual shareholder meetings on Wednesday.
Valuations are still high: Oil prices may be lower than they were a year ago, but the stocks don’t look that cheap, according to research by investment strategist Ed Yardeni.
“The energy earnings outlook still remains pretty dismal compared to a year ago” says Yardeni.
Energy sector stocks had a P/E ratio of 14.1 in May 2014. Now the sector trades at 26.5 (based on forward earnings). That’s higher than the valuation for the overall stock market. The S&P 500 P/E is just shy of 17 — a figure many people are already calling lofty.
“It’s actually not cheap unless you think oil prices are going to rebound more,” Yardeni adds.
How to play it…safe: Most investors already have exposure to energy because they own mutual funds that invest in many U.S. stocks from different industries. So if energy rebounds, you get a win. And if it plummets again, you are protected somewhat.
If you want to go further than that, you will probably want to do your homework and only buy certain energy stocks (that’s what the hedge funds did) or buy a fund that just tracks the crude oil price.
“If you don’t own any, buy some,” says John Canally of LPL Financial in Boston. “But don’t get to more than 5% to 10% of your overall portfolio.”
