Oil Under $80: Here's What It Means For ETFs

November 05, 2014

With oil lower than it's been in years, there are some pockets of opportunity for investors.

In case you've been under a rock, the price of front-month West Texas Crude oil is currently just over $77. The last time it was at this level was in the summer of 2010, and it was at the same levels all the way back in 2007. The recent drop has been rapid and, short of a crisis like 2008, nearly unprecedented.

Most investors don't invest directly in oil, although ETFs like the United States Oil fund (USO | A-70) have certainly made it easier than ever before. Instead, most of us get our commodity exposure indirectly, through the equities we hold. Assuming this down-draft in oil isn't temporary, it's logical to ask who the winners and losers are in this new era of cheap oil.

Exploration & Production Punished

The knee-jerk response from most investors would be "cheap oil is bad for oil companies," and of course, there's some truth to that. Consider how the biggest energy ETFs with direct exposure to oil exploration and production companies, the SPDR S&P Oil & Gas Exploration & Production ETF (XOP | A-46) and the Energy Select SPDR (XLE | A-96), have fared:


While neither fund is as bad off as front-month crude has been (down 21 percent), XOP is down a whopping 16.6 percent for the year so far, driven by the shockingly bad performance of many of the smaller holdings in the fund. For instance, Energy XXI Bermuda, which has generally been about 1 percent of XOP by weight, is down almost 73 percent this year. A huge swath of exploration firms are down more than 30 percent on the year.


Wildcat Card

So why aren't these funds down even more? Well, because sometimes, wildcatters still strike it rich. XOP also owns a position in Athlon Energy, a shale oil production company that went public in 2013, started producing tons of crude, and is currently in the process of being gobbled up by Canadian giant Encana. That led to a 92 percent return for the 1.3 percent position in Athlon XOP held.

In fact, the irony of oil and gas exploration companies is that no matter how logical it is that they should be whipsawed by the price of oil, correlations are far from perfect. Here's the monthly correlation of the S&P Oil Exploration index to the price of crude over the past 10 years.


Certainly, during the steady rise and the stable highs of oil, producers and oils moved close to lock step. But not this year, and not all that often in the past.

The reasons are multifold—certainly some of the companies held by the larger energy ETFs have interests not tied directly to the price of crude: natural gas, for instance, which has been rising for its own reasons while the price of oil falls.

Others, like Exxon Mobile and Anadarko, have counteracting forces—they may be in refinery and transportation, which often benefit from the lower input costs of cheap crude, dampening the effect of short-term price declines.

Oil Transport Could Benefit

So are there clear winners and losers? Basic economics would suggest yes. While it's tough to make a buy recommendation on XOP right now, low crude prices over any extended period of time might suggest more demand, stabilizing prices and increasing the profitability of anyone in the business not just of selling the barrel of oil, but moving the barrel of oil from place to place.

For that reason, it seems unlikely that the master limited partnership ETFs are an instant short—the MLP indexes are chock full of companies that profit not on higher prices for energy, but increased utilization. More volume through pipelines and terminals means more transport fees, and lower prices, as I said, likely mean increased demand.

But to my mind, the real winners and losers in a cheap oil world aren't even directly in the business:


Cheap Oil Losers: Alternative Energy

Ticker Fund Name 1 Month 3 Month 1 Year 5 Year
TAN Guggenheim Solar -4.70% -1.17% 2.64% -11.62%
PBW PowerShares WilderHill Clean Energy -2.73% -1.73% -4.55% -7.43%
QCLN First Trust NASDAQ Clean Edge Green Energy -2.81% -3.28% 6.01% 6.42%
GEX Market Vectors Global Alternative Energy -1.65% -5.21% 4.50% -1.44%
PBD PowerShares Global Clean Energy -1.23% -1.16% 7.59% -3.52%
ICLN iShares Global Clean Energy -1.97% -5.95% 0.25% -10.26%
FAN First Trust ISE Global Wind Energy -3.19% -11.71% -1.22% -5.16%
KWT Market Vectors Solar Energy -4.53% -4.24% 0.75% -16.56%

I'm an environmentalist at heart, so it pains me to say this, but the complex of eight ETFs covering the renewable energy space does terribly in a world of cheap oil. After all, if you can get cheap oil to heat your house or power your factory, why are you going to pony up for a windmill or a solar panel?

Alternative energy products all have a breakeven based on the price of alternatives. If it costs $2,000 a year to heat your house with oil, and $20,000 to install a geothermal system, well, you have a 10-year payback. If the price of oil drops enough to make that $1,000 a year, well, a 20-year payback starts seeming like an awfully long-term investment.

Frackers Vulnerable

That breakeven math hits another group of companies even harder: fracking firms. Depending on whom you believe, the profitable point for fracking oil out of the ground is between $75 and $95. With oil flirting at the bottom range of those numbers, frackers are starting to face the same inexorable math that gold miners have been facing: At some point, it makes more sense to stop producing oil than to keep paying roughnecks to man the pumps.

A quick look shows how the one ETF tracking frackers, the Market Vectors Unconventional Oil & Gas ETF (FRAK | B-21), and the largest renewables ETFs, the Guggenheim Solar ETF (TAN | B-40) and the PowerShares WilderHill Clean Energy ETF (PBW | B-16) have weathered the latest oil news:


Just as important as the downdraft from oil, however, is the updraft all three funds received as the stock market itself has recovered in the past few weeks. Equities are, after all, always equities, no matter how tied they are to a particular commodity. Still, should oil sit under $80 for a long time, these would be hard ETFs to own.


Cheap Oil Winner? Airlines. But No ETF!

There are plenty of industries that have energy inputs as a significant cost of doing business: any company with a fleet of cars or trucks, any company selling cars and trucks, and any industry with significant energy use or petroleum feedstocks, like chemicals.

But if I had to pick one class of companies most directly and immediately influenced by the price of oil, it's airlines. A $20 drop in the price of oil is a direct bonus to the bottom line of any airline, and historically, the performance of airline stocks (proxied here by the NYSE Arca Airline index) is actually inversely correlated to oil more often than not:


Still, not everyone is convinced. Some analysts are wringing their hands thinking that airlines, faced with cheap oil, will go back to their over-expansive ways and reconfigure their businesses in ways that will spell disaster if and when oil spikes again.

ETF investors are faced with one of the terrible business decisions of all time made by the ETF industry: Where once there were two airline ETFs—one from Guggenheim and one from Direxion—there are now exactly zero. The last one, Guggenheim's FAA, closed in March 2013, right before the airline index went on a tear.


The index is now up 86 percent since Guggenheim took it off the market, and you can see how it would have responded to the last month of oil prices. It's a darn shame. The best ETF investors can do now is the SPDR S&P Transportation ETF (XTN | A-62), which has some 23.5 percent of its exposure to airlines, and an additional 13.5 percent in air freight. It competes with the iShares Transportation Average (IYT | B-66), which is inferior both for being based on an archaic price-weighted index and being much less of a pure transportation play.

Talk about shutting the barn door after the horse has left. Still, I think airlines are the solid play for sustained cheap oil. Too bad the ETF industry missed the boat.

At the time this article was written, the author held no positions in the securities mentioned. You can reach Dave Nadig at [email protected] or on Twitter @DaveNadig.


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