Riding Energy Fund XOP With Hedging Option

August 05, 2014

Cooling energy sector offers potential upside in an uncrowded trade.

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 is by Kim Arthur, chief executive officer and founding partner of San Francisco-based Main Management.

Energy is something we live with on a daily basis. Drive your car, and you’ll need to fill it up. Whether it’s electric or hybrid, you’ll need an energy source.

Whenever there is a geopolitical flare-up—this time we have Iraq, Gaza and Russia—we become even more sensitized to energy as we watch Brent crude and WTI crude prices creep ever higher. (Brent is a proxy for European/global prices and WTI for U.S. prices.) Currently, those prices are $105 and $97, respectively. How can you play this commodity and geopolitical scenario?

One way is to purchase the SPDR S&P Oil & Gas Exploration & Production ETF (XOP | A-52). XOP gives you exposure to 88 holdings, of which 80 percent are exploration and production (thus the name), and 15 percent are refining and marketing. The embedded fees are 35 basis points, or $35 for every $10,000 invested, and the fund has almost $1 billion in assets. This is predominantly a large-cap holding, with the weighted average market cap at $19 billion.

Given the 88 holdings, this fund is very diversified and not top heavy. What I mean by that is the top 10 holdings are less than 15 percent of the total assets.


Chart courtesy of StockCharts.com


2 Questions To Answer

Two questions need to be answered. First, have other investors already discovered this investment, therefore making it a crowded trade? Secondly, has Mr. Market bid XOP up to levels where the return potential does not outweigh the risk potential?

Tackling the first question, it’s important to see how other managers are positioned with respect to energy. Merrill Lynch has been conducting surveys with institutional investors for decades, asking such questions.

Currently U.S. large-cap active managers for the energy sector are 25 percent underweight, which is the largest underweight since 2008. The last time they were close to a full weight was the summer of 2011, just before China and the emerging markets began to slow their growth. Based on this, we now need to answer the absolute-value question of XOP.

Currently, XOP and its 88 holdings trade at just under 2.0x price-to-book, and just under 1.0 price-to-sales. This doesn’t mean much, unless we compare with to its absolute historical valuation. If we break the price-to-book and price-to-sales into deciles, we can get a snapshot of where we are historically.

Based on XOP’s price-to-book of 1.96, we’re at 60 percent, or the sixth decile, and based on XOP’s price-to-sales of 0.9, we are also at 60 percent, or the sixth decile. This means we’re closer to fair value, but still in the area where, given the sector’s underweight by active investors, we can continue.

Using Covered-Call Strategy

Finally, since the energy sector is so highly correlated to the price of oil (0.94 correlation), we should have an opinion of where it might go. Most analysts are forecasting $100 a barrel for Brent, with the current price at $105.

If we have a sustained geopolitical flare-up with oil supply disruption, oil could spike $40 higher. If we have a global recession, oil could collapse well below $100.

In fact, during the past three years, oil has traded between $100 and $126, and has been the most stable since the 1990s. With China growth stabilizing after a three-year consolidation, global growth could inch higher, and with 50 percent of energy sales being foreign sales, this is a good play on global growth.

Lastly, if you’re more income oriented and wish to risk-manage your downside with some current income, you can sell a covered call against your XOP position. Since the cash price has retreated 12 percent from the recent $84 high, the volatility has increased to 25 percent for the at-the-money September calls versus 15 percent for the broader market SPDR S&P 500 (SPY | A-98), which is less than 3 percent off its $199 highs.

This way you could limit your upside, but would protect yourself from another 4 percent downside or 15 percent from the recent high of $84. If XOP goes flat, you collect 3.6 percent yield for seven weeks, or half of 1 percent per week.

A pioneer in managing all-ETF portfolios, Main Management LLC is committed to delivering transparent, cost-efficient and customized investment solutions. By combining asset allocation insights with smart implementation vehicles, Main Management offers a unique approach that translates into distinct advantages for our clients, including diversification, cost efficiency, tax awareness and transparency. www.mainmgt.com.



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