Why Oil ETFs Are Rising Again

September 24, 2018

After a lull during the summer months, oil prices are on the rise again. Ahead of what has traditionally been the strongest quarter of the year, European Brent crude oil prices closed in on $80/barrel mark—just shy of the highest level of the year—while U.S. West Texas Intermediate (WTI) prices edged above $71, moving toward their high of the year around $75.

Even energy stocks, as measured by the Energy Select Sector SPDR Fund (XLE), are starting to rise again after briefly giving up most of their gains for the year in August.

Sagging Supply Surfaces

The latest catalyst for energy’s ascent: sagging supply from Iran and Venezuela. The International Energy Agency said last week that Iran’s oil exports tumbled by 500,000 barrels per day in anticipation of U.S. sanctions on the Iranian oil industry that go into effect on Nov. 4.

Bloomberg reported an even larger decline of 900,000 barrels per day, with exports dropping from 2.5 million to 1.6 million barrels per day between April and mid-September.

Meanwhile, with the economy melting down in Venezuela, oil production in that country has tumbled 350,000 barrels per day this year and could fall another 250,000 barrels per day or more, according to the IEA.

Hefty Gains For Oil ETFs

“If Venezuelan and Iranian exports do continue to fall, markets could tighten and oil prices could rise without offsetting production increases from elsewhere,” warned the agency.

The double whammy of Iran and Venezuela supply woes could be what kick-starts the next leg higher in energy prices, bolstering returns for energy-focused exchange-traded funds.

Oil ETFs, like the $101 million United States Brent Oil Fund LP (BNO) and the $1.7 billion United States Oil Fund LP (USO), are already up smartly this year—23% and 24.9%, respectively—thanks to the ascent in oil and futures curves in backwardation, which means near-month futures are more expensive than longer-dated futures.

 

YTD Returns For Oil ETFs & Oil Futures

 

The largest energy equity ETF, the $17.5 billion XLE, hasn’t done as well, lagging behind with a 5.6% gain, but more targeted ETFs like the $111 million Invesco Dynamic Energy Exploration & Production ETF (PXE) and the $3.3 billion SPDR S&P Oil & Gas Exploration & Production ETF (XOP), have better kept up with oil prices.

 

Top-Performing Energy Equity ETFs Of 2018

Ticker Fund YTD Return (%)
GUSH  Direxion Daily S&P Oil & Gas Exp. & Prod. Bull 3X Shares 22.7
PXE  Invesco Dynamic Energy Exploration & Production ETF 17.3
FTXN  First Trust Nasdaq Oil & Gas ETF 16.5
IEO  iShares U.S. Oil & Gas Exploration & Production ETF 14.7
CHIE  Global X China Energy ETF 14.5
XOP  SPDR S&P Oil & Gas Exploration & Production ETF 14.5

 

Those ETFs, chock-full of U.S. energy producers, have benefited from both the jump in crude prices and the surge in U.S. oil production. American oil producers have pushed output for the country up to a record 11 million barrels per day, an increase of 1.5 million barrels per day from a year ago.

The loss of Iranian and Venezuelan barrels from the market have allowed these producers to grow their production rapidly without creating a massive glut like the one that sent oil prices cratering from more than $100 to as low as $26 between mid-2014 and early 2016.

US Oil Production Surges

Sources: Energy Information Administration, Bloomberg

 

Perfect Environment

It’s the perfect environment for U.S. oil producers. At least for now, they have the green light to continue pumping full throttle, while enjoying relatively high prices that could head even higher.

Indeed, in the near term, the market is more likely to see a shortage of crude than a glut. A futures curve in backwardation, with near-month oil futures trading at higher values than later months, suggests there is a tight market for physical oil.

“As long as the backwardations continue to widen, you can’t be short of crude,” said Dennis Gartman, president of The Gartman Letter, who noted that oil prices could rally another $5 from here.

Supporting that bullish futures curve is demand, which is growing a brisk 1.4 million barrels per day from a year ago, and a lack of spare production capacity, with most producers pumping as much oil as they can.

It’s because of this that analysts say a meeting of OPEC producers on Sunday probably won’t result in a material increase in the cartel’s output, even as they discuss how to rejigger individual member quotas to reflect recent production gains in Saudi Arabia and other countries.

Understandably Cautious

While the prospects for further oil price increases are growing, energy investors remain understandably cautious, as gnawing memories of the downturn from a few years ago linger.

Analysts at Credit Suisse estimate that U.S. exploration and production companies are only discounting $51 WTI crude oil prices, well below current levels.

Some of that caution is warranted. U.S. production is going gangbusters, which was the catalyst for the previous crash in prices. At the same time, demand, while strong now, could stumble if consumers begin balking at rising fuel costs.

The boom/bust reputation of the oil industry means it may take a more sustained period of elevated prices before investors truly believe they are here to stay.

 

Email Sumit Roy at [email protected] or follow him on Twitter sumitroy2

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