Energy ETFs were the top-performing funds of the first half of 2022 by far, but a pullback in crude oil prices has cut into those gains. Since peaking at more than $120/barrel in June, U.S. West Texas Intermediate crude oil prices fell below $90 last week for the first time since early February.
WTI is now up less than 20% on a year-to-date basis, down from more than 60% at the two price peaks in March and June.
The $2.2 billion United States Oil Fund LP (USO), which holds WTI futures contracts, has followed a similar path. This ETF has outperformed thanks to a futures curve in backwardation. With near-month oil futures contracts priced more expensively than later-month contracts, USO has been able to sell high and buy low as the fund has sold expiring near-month contracts to purchase later-month contracts.
In addition to weighing on oil futures ETFs, the pullback in oil prices has hit energy stock ETFs. Since the start of the year, the $36 billion Energy Select Sector SPDR Fund (XLE) gained around 34%, easily enough to make it this year’s top-performing fund within the SPDR sector suite. It is still well below the ETF’s 68% return at its peak.
Year-to-date returns through Aug. 8, 2022
Narrower energy stock funds, like the iShares US Oil & Gas Exploration & Production ETF (IEO), the VanEck Oil Refiners ETF (CRAK) and the First Trust Natural Gas ETF (FCG), have followed the same trajectory—a steady rally through early June and then a decline that’s cut their gains from massive to smaller advances that are still significant.
Year-to-date returns through Aug. 8, 2022
Makeup of the Industry
Exxon Corp. and Chevron Corp., which together make up nearly half of the weighting in XLE, generate profits primarily from their upstream fossil fuel production businesses and their downstream refining businesses.
In the upstream business globally oil accounts for around 60% of volumes, while natural gas accounts for 40%. The refining business has represented about a quarter of profits for both companies this year.
As volatile as oil prices have been in 2022, U.S. natural gas prices have been even more so, rising from $3.73/mmbtu at the start of the year to as much as $9 on the back of low inventories and growing exports to energy-hungry Europe.
Refining margins—the profit that refiners make for buying oil, refining it into usable end-products like gasoline and diesel, and then selling those—have also swung wildly. They tripled from the start of the year to their June highs—the loftiest levels ever—before retreating to today’s lower, but still historically elevated, levels.
Refining Margins (3-2-1 Crack Spread)
While integrated oil companies like Exxon and Chevron focus on all aspects of the energy business, the more numerous smaller energy companies tend to focus on one area, like upstream oil production or refining.
You can find those in the broad XLE, as well as narrower energy ETFs, like the aforementioned IEO, CRAK and FCG.
Moving in Tandem
Though oil, natural gas and refining margins can move up and down on their own, this year they’ve tended to move in tandem.
Rising demand due to a normalization of the global economy after the pandemic, as well as tight supplies due to a lack of investment in previous years on top of disruptions caused by the Russia-Ukraine war, have all driven energy prices up across the board.
There’s been a lot of effort made to tame energy prices, by releasing oil from strategic government reserves, making appeals to leading oil producers like Saudi Arabia, and ramping up production in places where it’s relatively easy to start and stop drilling quickly—like the U.S.
While these initiatives seemed to have worked to some extent, they may act more like a band-aid than a sustainable solution to tight energy supplies. Demand for oil and natural gas has never been higher, and is expected to keep creeping up in the near term amid increasing consumption in emerging markets.
Satisfying that demand will be a challenge for an industry that is well-aware that the world is shifting from fossil fuels in the coming decades. Somehow, the market and policymakers must encourage oil and gas companies to continue to invest in their businesses in the face of an inevitable drop-off in demand in later years.
If not policymakers, then the market will provide the incentive through high prices, as we’ve seen in the first half of 2022.
“Global oil inventories remain critically low,” with “readily available spare capacity running low in both the upstream and downstream, the International Energy Agency noted in its latest oil market report. “Without strong policy intervention … risks remain high that the world economy falls off-track for recovery.”
Follow Sumit Roy on Twitter @sumitroy2