Oil Sell-Off A Buying Opportunity In Energy ETFs

July 28, 2016

After a strong five-month rally that saw prices nearly double off their lows, oil hit a bit of a road bump in July.

Analysts point to a glut of crude oil and gasoline in storage tanks in the United States and elsewhere as the cause of the decline. As of last week, crude stockpiles in the U.S. were 62 million barrels, or 13.3% above the year-ago level, while gasoline stockpiles were 26 million barrels, or 11.8% above the year-ago level, according to the Energy Information Administration.

WTI crude oil prices sagged to less than $42/barrel on Wednesday, down 19% from highs of more than $51 in June.

To be sure, the magnitude of the current slide isn't anywhere close to what transpired in January and February, when oil dipped to $26/barrel, fueling a broad sell-off in stocks and high-yield bond markets.

This time around, the SPDR S&P 500 ETF (SPY | A-97) and the iShares iBoxx $ High Yield Corporate Bond ETF (HYG | B-68) have barely flinched. SPY is essentially at record highs, while HYG is close to a nine-month high.

YTD Price Charts For Oil Futures, SPY, HYG

Should investors be more concerned about the renewed decline in oil prices than they currently are?

Fundamentals Stronger

A look at the fundamentals of the oil market suggests that investors may be right to not panic. The outlook for oil today is significantly different than the outlook at the start of the year.

For one, U.S. oil production is substantially lower than where it was on Dec. 31―700,000 barrels per day, or 8% lower (from its highs of last year, output is down a whopping 1.1 million barrels per day). The recent decline in oil prices will only serve to discourage production even more, keeping pressure on a key source of supply.

 

US Lower 48 States Crude Oil Production (thousand barrels per day)

At the same time, global demand is up big―by 1.4 million barrels per day year-over-year―according to the International Energy Agency.

Put the two together and you have a market that's made an "extraordinary transformation from a major surplus in [Q1] to near-balance in [Q2]," said the IEA in a recent report.

If these trends keep up, it's not hard to imagine that the oil market will move into a deficit sometime in 2017.

Buying Opportunity

Based on this outlook, it's unlikely that oil prices will fall anywhere close to where they were earlier this year. That's what the stock market and the junk bond market may be assuming, and helps explain the lack of panic in the air.

If anything, the recent pullback in oil may be a buying opportunity in energy ETFs, which have corrected modestly along with the commodity.

The Energy Select Sector SPDR Fund (XLE | A-92) is up 12.1% in the year-to-date period through July 27, but it is down 4% from its recent highs. The ETF, which has heavy weightings in integrated oil giants such as Exxon and Chevron, is one of the safest ways to get exposure to the energy sector, but it doesn't provide the biggest bang for an investor's buck.

ETFs that target smaller, independent oil producers, such as the SPDR S&P Oil & Gas Exploration & Production ETF (XOP | A-70), the iShares U.S. Oil & Gas Exploration & Production ETF (IEO | A-78) and the VanEck Vectors Unconventional Oil & Gas ETF (FRAK | B-25), offer more leverage to any potential rebound in crude prices.

Each of those ETFs is down almost 10% from recent highs, though they're all still in the green for the year as a whole.

XOP holds an equal-weighted basket of exploration and production (E&P) stocks, giving each holding about a 1.7% weighting in the fund on average.

IEO also focuses on E&Ps, but uses a market-cap-weighted approach. In turn, stocks of large E&Ps like ConocoPhillips and EOG Resources have a much larger weighting in the ETF than smaller ones like Oasis Petroleum or Denbury Resources.

Meanwhile, FRAK takes a slightly different tack by tracking an index of companies involved in unconventional oil and natural gas production. These are the companies at the heart of the U.S. shale boom, such as EOG, Pioneer Natural Resources, and others. FRAK is heavy on E&Ps, and its holdings see significant overlap with IEO and XOP.

In terms of performance, FRAK is leading the way this year, followed by XLE, XOP and then IEO.

 

YTD Performance For FRAK, XLE, XOP, IEO

However, longer term, XLE and IEO are well ahead of the pack, as can be seen from the charts below:

Returns For FRAK, XLE, XOP, IEO Since Feb. 14, 2012

 

Returns For XLE, XOP, IEO Since July 27, 2006

 

If oil prices rebound back above $50 or even $60 later this year, as fundamentals suggest they might, all four of the aforementioned energy ETFs stand to benefit. But each offers slightly different exposure to the space that investors should be cognizant of.

Contact Sumit Roy at [email protected].

 

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