Energy ETFs Lag As Rising Oil Tops $60

Just when everyone left it for dead, oil prices are making an impressive comeback. Brent crude oil futures reached $61 on Monday, the best level of 2017 and the highest price since July 2015.

But not everyone believes the rally in crude is sustainable. While certain energy ETFs have followed Brent prices higher, others have lagged behind. What's going on?

Brent Crude Oil Price

Production Cut Extension

To answer that question, it's important to consider why oil prices are rising. According to news reports, the most recent upswing can be attributed to talk about OPEC and Russia potentially extending their production curbs beyond March 2018.

"The Kingdom affirms its readiness to extend the production cut agreement, which proved its feasibility by rebalancing supply and demand," Saudi Arabia crown prince Al Saud said earlier this week.

The production cuts―which were already extended once in May and total nearly 1.8 million barrels per day―have played a large part in helping to balance an oil market that's been weighed down by excess supply.

In a recent report, the International Energy Agency (IEA) said that oil inventories have fallen for three quarters in a row, and may remain stable next year if OPEC maintains its current production levels.

"There is little doubt that leading producers have recommitted to do whatever it takes to underpin the market and to support the long process of rebalancing," said the IEA.

WTI Lags

If the OPEC-Russia supply pact is the reason for oil's ascent, it's had an uneven impact on the various energy ETFs.

The United States Brent Oil Fund (BNO) is up 4.8% this year, but the United States Oil Fund LP (USO) has lagged far behind, with a loss of 6.6%.

YTD Return For USO, BNO

USO tracks West Texas Intermediate crude oil futures―WTI for short. That oil benchmark was last trading at only $54, a steep discount to Brent, due to climbing production in the U.S. and the limited ability to arbitrage away the difference.

"Logistical constraints saw crude oil stocks increase at Cushing, causing [WTI's] discount to Brent to blow out to nearly $7/bbl from only $2/bbl in June," explained the IEA.

Oversupply Fears

USO isn't the only oil-linked ETF to underperform. The Energy Select Sector SPDR Fund (XLE) is down 7.4% so far in 2017, making it one of the worst sector ETFs of the year.

There's been a reluctance on the part of analysts and investors to believe that higher oil prices are here to stay, which has capped shares of energy stocks.

“The market is frightened by the shale oil band,” Olivier Jakob of PetroMatrix told the Financial Times. “But it’s not just traders—we’ve seen indications from OPEC and Russian oil companies that even they think going above $60 a barrel right now would be too much and would bring on more oil from shale."

Opportunity To Buy

The fear that another wave of supply could hit the market as prices creep higher has prevented energy ETFs from fully participating in oil's latest move higher. But some analysts see that as an opportunity to buy.

"West Texas Intermediate crude oil is up over 20% since its June low but the energy sector has rebounded less than 10%. We see outperformance for the sector as it reacts to the trend of higher oil prices that are being driven by year-over-year declines in total petroleum inventories," said analysts at Ned Davis Research Group.

They recommended buying energy equipment and services stocks, such as those held by the $1.1 billion VanEck Vectors Oil Services ETF (OIH), over the 'big oil' stocks that dominate ETFs like XLE.

"Big oil, while possessing stronger financials, has become a darling of low-beta, high quality and dividend ETFs, which should underperform as rates rise," they explained.

YTD Returns For XLE, OIH

Contact Sumit Roy at [email protected]