XLE ETF: Double Digit Dividend Growth Should Be Sustainable (2024)

Sometimes trying to get solid annual returns is better than seeking to maximize capital gains. With rates high, economic expectations low for this year, and uncertainty at higher levels with political elections coming up, finding good investments in the market today is difficult.

A more common investment choice today has been exchange-traded funds, and one of the better-performing ETFs over the last three years has been the Energy Select Sector SPDR Fund ETF (NYSEARCA:XLE).

XLE has offered investors total returns of 104% since the middle of 2021, while the S&P 500 (SPY) has offered investors total returns of 30.04% during this same time frame.

I last wrote about XLE in October 2023. I rated the fund a buy primarily because of the positive outlook for energy prices and the likely dividend growth of the fund. I am upgrading the ETF to a strong buy today. The outlook for oil prices has improved recently for multiple reasons, and the valuation of the core holdings of this fund are still likely undervalued. XLE should be able to sustain double-digit dividend growth and continue to offer solid overall returns as well.

The Energy Select Sector SPDR Fund has an expense ratio of .09%, $39.62 billion in assets under management, and a current yield of 3.11%. The fund has just 25 holdings, and the top 10 investments make up nearly 79% of the ETF's overall assets. XLE's biggest holdings are Exxon Mobil (XOM) and Chevron (CVX), which comprise a combined 44% of the fund.

XLE has delivered both strong income and total gains over the last 3 years. The fund's dividend growth since 2021 is 11.83%, and the energy ETF's dividend growth over the last 5 years is 7.10%. Even though this fund is obviously not likely to appreciate at 30% per year moving forward, as this ETF did since 2021, the outlook for XLE remains strong.

Oil prices have remained high over the last year, even as the growth outlook in the US and abroad has deteriorated for multiple reasons. The war between Ukraine and Russia continues, with Ukraine and Russia increasingly targeting refineries and energy infrastructure. Most of the current oil production is coming from oil discoveries made in the twentieth century, and energy companies are having trouble making major new discoveries. Energy companies are also spending significantly less money on capex today than 10 years ago, and experts are expecting shortages in the oil market by the end of 2025. Capex spending in the energy industry is also expected to fall in 2024 from 2023 levels.

Goldman has also stated the firm expects peak oil demand for road vehicles to be between 2025 and 2032. The CEO of Occidental Petroleum (OXY) recently stated that she expects significant supply issues in energy markets in late 2025. The EIA expects oil prices to average $82 a barrel in 2024, and Bank of America also recently raised the price estimate for crude prices this year to a range of $81-$86, with the bank expecting prices to peak at $95 a barrel in the summer. Energy prices have proven to be very resilient even in the current weak economic environment.

The energy industry is also expected to see near-record cash flow moving forward, and valuation levels remain at low levels using recent averages. The largest 5 oil companies in North America have generated a combined $613 billion in free cash flow over the last 3 years. Cash flow in the oil and gas industry has been so strong that demand for new loans has fallen for consecutive years, with demand falling 6% in 2023. Most oil majors have also significantly reduced the debt many of these producers took on during the Pandemic. Analysts are forecasting the oil and gas industry to generate between $2.5-4.6 trillion in free cash flow between 2023-2030.

Exxon Mobil and Chevron both look cheap as well. Exxon is currently trading at 6.31x predicted forward EBITDA and 13.02x forecasted forward non-GAAP earnings. The oil producer's 5-year average valuation is 7.32 expected forward EBITDA and 15.48x predicted forward non-GAAP earnings. Chevron is trading at 6.04x forecasted forward EBITDA and 1.62x predicted forward sales. The company's average 5-year valuation is 6.74x expected forward EBITDA, and the sector median valuation is 2.01x forecasted forward sales. Both energy majors also have the cash flow to accelerate share buybacks and dividend payouts moving forward as well. Refining margins have also recovered nicely this year because of lower utilization rates in the industry in Russia and the US, and the weak North American natural gas market has also been priced into these companies valuations for some time. Valuations across the energy and gas sector look cheap, with e sector median price to earnings ratio for the upstream industry nearly 13x trailing earnings.

While all investments have risks, and if the conflicts in the Middle East and the war between Russia and Ukraine were to end, that would obviously probably lead to lower energy prices, these conflicts remain likely to continue as the US just approved a massive aid package for Zelensky's government, and Israel remains committed to eliminating Hamas. A recovery in refinery utilization rates in the US and Russia would also put pressure on the crack spreads in this industry and bring oil prices down modestly. Still, these scenarios remain unlikely.

Oil prices won't likely rise as much over the next decade as we saw between 2020 and 2024 as the market struggling to meet pent-up demand coming out of the pandemic. Still, valuations remain low across the energy industry and these companies are still seeing near-record cash flow. The outlook for energy prices this year and moving forward remains strong as well, with major new oil discoveries becoming increasingly more difficult to come by. If investors are seeking strong income and decent overall returns, XLE should be an appealing option.

Skeptical12