A Good Way to Play Small Cap Energy Stocks

Over the next few weeks, I will be buying something that, for years now, has been extremely disappointing. If that makes no sense to you, bear with me for a bit. The play is based on a strategy almost as old as the stock market, and a news story that makes now seem like a good time to employ it.

The principle of reversion to the mean, the idea that sectors and stock styles fall in and out of favor but always return to their long-term average relationship, is one of the oldest and most influential in the worlds of trading and investing. It is the basis of contrarian trading, which regular readers will know is my preferred style, and if used properly, inevitably leads one to follow the most basic advice for traders and investors: to buy low and sell high.

It is also the reason I have been sniffing around some small cap energy stocks recently. Both of their defining characteristics make them look like a buy, as small cap stocks and energy stocks have both lagged the broad market index, the S&P 500, quite considerably over the last couple of years. The problem is that small cap energy stocks are often small, and stay small, for a reason. Without big resources on which to draw, it is hard for small E&P or integrated firms to grow, and small alternative energy companies are usually at a disadvantage competing with the big boys when it comes to the capital investment needed to keep pace with technological advances.

However, there is right now a dynamic that could benefit small caps and allow them to revert to that mean that has been elusive for a while.

Big oil is under fire. I know that is hardly breaking news. Big oil has been under fire for decades, but the most recent attacks in the US Congress are a little different in that they are supposedly based on something other than envy or a hatred of fossil fuels. An FTC investigation reportedly has firm evidence in the form of emails and text messages that show that the founder of Pioneer Natural Resources, Scott Sheffield, colluded with OPEC and OPEC+ to set US output and therefore influence oil and gas prices in America.

That story has engendered an atmosphere of distrust and led to the House Committee on Energy and Commerce demanding communications and records from multiple big oil firms that they believe may show that those firms did the same thing. The Sheffield case has yet to come to court, of course, let alone there being any proof of the broader suspicions or allegations, but firms like Exxon (XOM) and Chevron (CVX) will be feeling under pressure, and that pressure could result in them cutting back. That, in turn, could easily result in a bit of a fire sale of assets.

That is completely speculative, obviously, but it doesn’t have to be completely correct for small cap energy stocks to benefit. Even a chance of small cap energy companies getting a bit of an edge, or a belief that they might, when combined with the idea that a reversion to the mean is coming makes them attractive at current levels.

The point here is not to find individual stocks but rather to play the size and sectors that have generally underperformed. And as is so often the case these days, there is an ETF for that.

The Invesco Small Cap Energy ETF (PSCE) is exactly what its name suggests. Its holdings run the gamut of energy industries, from E&P to refining and marketing, touching oilfield services and midstream companies, too. Most notably, as the extract from Invesco fact sheet for the fund below indicates, it is focused on oil and gas, which is where the opportunity is if things play out as anticipated.

Most of all, though, this is a reversion to the mean play. As you might expect with small cap and energy stocks both underperforming the market, small cap energy stocks have really underperformed.

Figure 1: 2 Year comparative chart for PSCE (main body), XLE (blue line), and SPY (green line).

To some, that kind of two-year record would be off-putting. But to me, who was taught forty years ago that it wasn’t a matter of if underperformers would revert to the mean, but when, and who built a decades-long career off of respecting that, it looks like an opportunity, so I will be averaging into a long-term long position in PSCE over the next few weeks.