Kotok: Avoid XLE For Now

December 04, 2013

Fruits of ‘fracking’ mean investors ought to underweight energy, Kotok says.

This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today’s article features David Kotok, chairman and chief investment officer of Sarasota, Fla.-based Cumberland Advisors.

A look at the energy markets shows that the prices of the U.S. benchmark oil (WTI) and the international or European benchmark oil (Brent) have been falling since the middle of August 2013.

This move is emblematic of a broad downward pressure on U.S. energy prices that is behind our being underweight energy, which means, in part,  scaling back on sector-specific ETFs such as the Energy Select Sector SPDR Fund (XLE | A-92).

First, a bit of background about crude oil markets.

The WTI and Brent markets are geographically distinct with separate forces at work in each. The usual arbitrage that once kept the two prices close to each other seems to be gone, and the spreads—currently almost $17—between them have been unusually wide for several years.

The U.S. price is influenced by the build-out of America's energy infrastructure and exploration sector. As a nation, we are producing more of our own oil and natural gas. We are consuming more of our own domestic production, and we are importing less than we used to.

We are also now more efficient in the way we consume energy. All of this is beneficial to the U.S. And all of this exerts a downward pressure on U.S. energy prices.

Let's add to that mix the discovery of huge new fields and the development of new technologies in the production of oil and natural gas. The resulting energy outlook for the U.S. is favorable for the next several decades.

Things are different when it comes to Brent crude and non-US oil pricing. Geopolitical events are acting adversely in Iraq, Libya, Nigeria, and other places where crude oil is sourced. Saudi production is up and has closed some of the gap.

The ongoing geopolitical turmoil injects higher costs and the need for larger inventories. Hence additional risk premia factor into the pricing. Were peace to break out in a durable fashion in the world, the price of Brent oil would drop significantly.

Back in the U.S., the marginal cost of oil production is arguably somewhere in the $70s. The trading price is in the $90s. We may expect the price of U.S. oil to fall over time as additional production is developed.

That may cause continuing downward price pressure on gasoline prices. It will also mean that transportation cost pressures will be alleviated because energy is a great portion of that cost.

This trend translates to downward pressure when it comes to inflation.

Take the pervasive cost structure of energy, lower the price, and have it trend downwards. You will ease inflationary pressure—both directly in terms of lower energy costs and indirectly in terms of the prices of all of the things that depend, in one way or another, on our domestic energy.

The energy sector amounts to about 11 percent of the S&P 500 Index. That is a heavier weight within the stock market and substantially influences market performance.

Big-cap American companies like Exxon and Chevron are large weights in some of the ETFs that are broad-based, like the SPDR Dow Jones Industrial Average Trust (DIA | A-70) or the SPDR S&P 500 ETF (SPY | A-98).


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