After two-straight years of plunging prices, 2016 is shaping up to be a year of recovery for oil.
Prices for U.S. benchmark West Texas Intermediate (WTI) oil futures contracts were last trading around $45/barrel, up 21% year-to-date. That's a much better showing than the 46% drop in 2014 or the 30% decline in 2015.
From a price perspective, it's safe to say that the worst of the oil bust has passed now that prices have nearly doubled off their lows of $26 from earlier this year.
From a fundamental perspective, things seem to be moving in a bullish direction as well. As of this writing, data from the Energy Information Administration shows that U.S. crude oil production is down to less than 8.5 million barrels per day, a drop of 1.1 million, or 11.5%, from the highs of last year.
U.S. Crude Oil Production (thousand barrels per day)
At the same time, global oil demand is up 1.4 million barrels per day this year to a record-high 96.3 million, according to the International Energy Agency (IEA).
The narrowing of the gap between supply and demand may lead to a "hefty draw" from inventories in Q3, according to the IEA. That would be the first time demand exceeded supply on a quarterly basis in almost three years.
Not Smooth Sailing
To be sure, despite the improving fundamentals, there are plenty of obstacles for the oil market ahead. Inventories remain exceedingly high and must be drawn down before the market truly rebalances.
Meanwhile, some U.S. oil producers have been accelerating their drilling activity as prices have rebounded, hinting that output may stabilize or even rise at some point down the road.
On the other hand, recent talks between OPEC and Russia to freeze their production levels have lent a bullish hand to prices. The push and pull of these various factors will likely keep oil traders guessing for the foreseeable future.
Contango Eats Away At Oil ETF Returns
In any case, things are much better in 2016 on the oil front than they were a year ago, fueling most energy-related ETFs to gains this year—but not all of them.
Ironically, performance for oil futures-tracking ETFs has been lousy. For example, the $2.9 billion United States Oil Fund (USO) is down 5.6% year-to-date—a far cry from the 21% gain for oil futures themselves. The underperformance stems from the roll costs associated from contango.
The United States 12 Month Oil Fund (USL), which holds 12 different futures contracts along the futures curve to mitigate contango, is doing a bit better, with a 4.8% gain, but it's still a laggard.
YTD Returns For WTI Futures, USO, USL
Rather, the best-performing energy ETFs are in the equity space. These funds don't have to contend with contango and are often viewed as leveraged bets on the price of energy commodities.
The VanEck Vectors Coal ETF (KOL) is the top energy ETF, rising a whopping 80.2% so far this year. One of the most beaten commodities, coal has seen an uptick in 2016. Though it's too little too late for the largest U.S. coal producers—many of which fell into bankruptcy earlier this year—KOL's global portfolio of coal companies has benefited from the rise.
That said, going forward, coal faces increasing competition from natural gas both in the U.S. and abroad, and is thus considered one of the riskiest energy commodities.
MLPs Bounce Back
After KOL, some of the best-performing energy ETFs are those that hold pipeline and other energy infrastructure stocks. The Tortoise North American Pipeline Fund (TPYP) and the Alerian Energy Infrastructure ETF (ENFR) are among those, rising 37.2% and 34.5%, respectively.
TPYP and ENFR are two ETFs in the complicated MLP segment of the market. MLPs are known for their steady cash flows and juicy dividends, something that kept them resilient during the early part of the oil bust. However, once U.S. crude production began to decline last year, MLPs were crushed amid fears that those cash flows would be eroded.
This year's rebound in oil prices has alleviated those fears, boosting TPYP, ENFR and others in the space.
In terms of holdings, both TPYP and ENFR cap their exposure to tax-advantaged MLPs at less than 25%. This contrasts to the big behemoths in the space, the Alerian MLP ETF (AMLP) and the J.P. Morgan Alerian MLP Index ETN (AMJ), which are both 100% allocated to MLPs (AMLP and AMJ are in the middle of the pack this year, with gains of 13.5% and 15.2%, respectively).
YTD Returns For TPYP, ENFR, AMLP, AMJ
E&P ETFs Outperform
Close behind the midstream ETFs are a pair of oil & gas exploration and production ETFs that have also surged this year. These funds hold stocks of energy companies that explore, drill for and produce the oil and gas from wells in the ground—those most associated with the "shale revolution" in the U.S.
The VanEck Vectors Unconventional Oil & Gas ETF (FRAK) is at the top of the pack when it comes to E&P ETFs. Its gain of 34.3% comes ahead of the next-best-performing E&P ETF, the SPDR S&P Oil & Gas Exploration & Production ETF (XOP), which has a return of 25.8%.
FRAK holds a market-cap-weighted basket of companies involved in unconventional oil and gas production. Top holdings include Occidental Petroleum, EOG Resources and Pioneer Natural Resources.
XOP takes a different tack by holding an equal-weighted basket of stocks across the E&P space.
Both ETFs differ significantly from the $15 billion Energy Select Sector SPDR Fund (XLE), which has a big weighting in integrated oil giants such as Exxon Mobile and Chevron. XLE is up 17.8% so far this year.
YTD Returns For FRAK, XOP, XLE
Big Flows Into Leveraged Oil ETNs
Even as energy ETFs have performed well this year, they haven't garnered much interest from investors. That's understandable; after the beating the sector took in 2014 and 2015, it's natural for investors to be shy about wading back into this notoriously volatile part of the market.
That said, there have been a few ETFs to see notable inflows in 2016. Those include the First Trust Energy AlphaDEX Fund (FXN) and the aforementioned XLE, each with inflows of $1.2 billion.
FXN, which is up 11% this year, uses a quant-based model to select its holdings. XLE, of course, tracks a market-cap-weighted basket of all the energy stocks within the S&P 500.
Also garnering significant flows this year is the aforementioned AMLP, with creations of more than $900 million, and the Etracs Alerian MLP Infrastructure Index ETN (MLPI), with creations of almost $310 million.
Finally, the VelocityShares 3x Long Crude Oil ETN (UWTI) and the VelocityShares 3x Inverse Crude Oil ETN (DWTI) are a pair of leveraged ETNs that have been popular with traders this year, garnering inflows of $640 million and $480 million, respectively.
UWTI and DWTI are designed for aggressive traders to bet on short-term moves in crude oil futures prices. The former is down 44.1% this year, while the latter is down 58.3%. Leveraged oil ETFs suffer from performance drag due to daily rebalancing and are only meant for very-short-term holding periods.
Contact Sumit Roy at [email protected].