The energy sector has suffered a steep decline over the past several quarters, as a slowdown in emerging markets reduced demand for crude oil and natural gas. So far this year, crude oil prices have fallen more than 20% and natural gas prices have dropped more than 25%. The commodities resumed their downward trend throughout October as well, with natural gas falling more than 12% and crude oil dropping by around 6%.

Given the substantial drop, many investors are asking themselves whether the commodities have been oversold and energy funds may be well-positioned for a recovery.

Underlying Fundamentals

Crude oil and natural gas prices began their descent as domestic production nearly doubled over the past six years, which forced foreign oil producers to compete with each other for emerging and developed end markets. Unfortunately, China’s economic growth may be worse than expected, as evidenced by its unexpected currency devaluation, while Europe’s recovery is proceeding at a slow pace that probably won’t surprise to the upside for some time.

On the supply side, production levels kept rising in Canada, Iraq, and even Russia. The lower prices have encouraged many producers to increase supply in order to make up for lost revenue, which has compounded the declines over time. With prices trending so low, the good news is that there’s signs that production is beginning to fall in the U.S. and some other countries with higher production costs, due to a drop in exploration investments.

The world’s leading oil cartel, OPEC, may also be partly to blame for the dramatic fall in energy prices. Since failing to cut production in 2014’s meeting, benchmark crude oil prices have fallen more than 50%, but no action has been taken to intervene in order to stabilize the market.

Finding Opportunities

The energy sector may be toxic for many investors, but there are some niche opportunities in the space. In early October, U.S. mutual funds began acquiring shares of independent refineries like Tesoro Corp. (NYSE: TSO) and Valero Energy Corp. (NYSE: VLO) that are taking advantage of cheap crude oil prices. These companies purchase crude oil at low prices as feedstock for refineries, and then output gasoline and diesel at much higher prices.

Actively managed mutual funds have become especially fond of these refiners, such as the popular Fidelity® Contrafund® Fund (FCNTX) and MFS® Research Fund (MFRFX). However, some other fund managers worry that the involvement of momentum funds could point to an overbought environment. After all, these funds may quickly dump the stocks as soon as the market begins to turn south, putting significant downside pressure on them.

As for the rest of the energy sector, the best chances for a turnaround hinge on a successful global economic recovery that seems increasingly elusive. China’s industrial production figures remain on the decline, which is a bad sign for energy demand from Asia, while the ECB’s decision to (almost certainly) announce more stimulus is indicative that the region’s problems may be resurfacing and could jeopardize the progress made so far.

The Bottom Line

The global energy sector has experienced a sharp decline over the past year. On the demand side, Chinese and European economic weakness has reduced demand for crude oil to support a growing economy. On the supply side, the U.S. has doubled its production over the past six years, while OPEC hasn’t done anything to stop other producers from pumping more, either.

These dynamics have left most of the energy industry in a tough place, which will require a rebound in the global economy to remedy, although refiners have been a bright spot for many mutual funds that have increased investments in the space. Investors looking for a lower cost alternatives to these funds should consider an energy tracking ETF like XLE.

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