What Lies Ahead For Oil & Gas ETFs?

Crude Oil Outlook

So far, 2016 has not been smooth sailing for the U.S. oil futures. The commodity has been very volatile this year with prices recovering from a 12-year low of $26.21 a barrel in February to $50/barrel mark in early June, slipping again to under $40 only to rally toward $50 once more.

While factors like Canadian wildfires, Nigerian outages/disruptions, production issues in Venezuela and a strike by Kuwaiti oil workers contributed to jump in prices earlier this year that saw the benchmark recover significantly, these issues have largely vanished from the market. As of now, overproduction of crude and a glut of refined products keep the commodity under pressure.

At over 520 million barrels, current crude supplies are up 16% from the year-ago period and are at the highest level during this time of the year. As it is, improvement in oil fundamentals remain fragile with the existing stocks of refined product inventories – gasoline and distillate – remaining at their maximum seasonal levels in at least 20 years despite healthy demand. Piling on the misery is the Baker Hughes report revealing a steady rise in the U.S. oil rig count and pointing to the resurgence in shale drilling activities.

A number of major industry players, including Exxon Mobil Corp. (NYSE:XOM), Royal Dutch Shell (LON:RDSa) plc (RDS.A) and BP plc (LON:BP) have reported sub-standard second-quarter numbers as lower energy prices take a toll. (Read: 6 Quality ETFs to Sail Through Uncertain Markets)

Over the past few weeks, West Texas Intermediate (WTI) crude futures have surged to over $45-a-barrel on renewed expectations of a production freeze from the 14-member OPEC bloc and Russia. However, several analysts have expressed skepticism over this mini-rally, pointing to the last such attempt made in April that failed spectacularly.

Oil is facing the heat on several other fronts as well. Perhaps most important pertains to the mounting worries about China’s crude demand. In particular, the Asian giant’s currency devaluation has stoked speculation about soft economic growth in the world’s No. 2 energy consumer.

What’s more, in the absence of production cuts from OPEC, the resilience of North American shale suppliers to keep pumping despite crashing prices, and concerns over the effects of Brexit on crude demand., not much upside is expected in oil prices in the near term. Moreover, a stronger dollar has made the greenback-priced crude more expensive for investors holding foreign currency.

As it is, with inventories at the highest level during this time of the year, crude is very well stocked. On top of that, the top producers of Middle East – pumping at full throttle – have indicated time and again that they are more intent on preserving market share rather than attempting to arrest the price decline through production cuts. Therefore, the commodity is likely to maintain its low trajectory throughout 2016.

In our view, crude prices in the next few months are likely to exhibit a sideways-to-bearish trend, mostly trading in the $35-$45 per barrel range. As North American supply remains strong and demand looks underwhelming, we are likely to experience pressure to the price of a barrel of oil. (Read: ETFs to Watch As IEA Forecasts Weaker Oil Demand)

Natural Gas Outlook

"It's cleaner, it's cheaper and it's domestic."

- Legendary energy entrepreneur T. Boone Pickens, in reference to natural gas.

Over the last few years, a quiet revolution has been reshaping the energy business in the U.S. The success of ‘shale gas’ – natural gas trapped within dense sedimentary rock formations or shale formations – has transformed domestic energy supply, with a potentially inexpensive and abundant new source of fuel for the world’s largest energy consumer.

With the advent of hydraulic fracturing (or "fracking") – a method used to extract natural gas by blasting underground rock formations with a mixture of water, sand and chemicals – shale gas production is now booming in the U.S. Coupled with sophisticated horizontal drilling equipment that can drill and extract gas from shale formations, the new technology is being hailed as a breakthrough in U.S. energy supplies, playing a key role in boosting domestic natural gas reserves. As a result, once faced with a looming deficit, natural gas is now available in abundance.

Statistically speaking, the current storage level – at 3.350 trillion cubic feet (Tcf) – is up 275 Bcf (9%) from last year and is 350 Bcf (12%) above the five-year average. Expectedly, this has taken a toll on prices. Natural gas peaked at about $13.50 per million British thermal units (MMBtu) in 2008 but dropped to its lowest level in almost 17 years – at $1.611 per million Btu (MMBtu) – in the first quarter. Apart from plentiful stocks, which hit an all-time high in November, the selloff was spurred by tepid demand for the fuel due to mild weather spurred by the El Niño phenomenon.

In response to continued weak natural gas prices, major U.S. producers like Cimarex Energy Co. (NYSE:XEC), Cabot Oil & Gas Corp. (NYSE:COG) and Range Resources Corp. (NYSE:RRC) have all taken significant cost-cutting measures, including a reduction in their capital expenditure budgets.

With production from the major shale plays remaining strong and the commodity’s demand failing to keep pace with this supply surge, natural gas prices have been held back. Industrial requirement has been lackluster over the past few years with demand barely rising. In fact, EIA estimates natural gas inventories will reach 4.042 Tcf by the end of October – a record level for that time of the year.

In the past, winter weather has played a factor in boosting prices with demand for domestic natural gas exceeding available supply. But with no dearth of new supply, even this association is becoming more and more obsolete. Finally, with improved drilling productivity offsetting the historic decline in rig count, we do not expect gas prices to rally anytime soon.

PLAYING THE SECTOR THROUGH ETFs

Considering the turbulent market dynamics of the energy industry, the safer way to play the volatile yet rewarding sector is through ETFs. In particular, we would advocate tapping the energy scene by targeting the exploration and production (E&P) group.

This sub-sector serves as a pretty good proxy for oil/gas price fluctuations and can act as an excellent investment medium for those who wish to take a long-term exposure within the energy sector. While all oil/gas-related stocks stand to move with fluctuating commodity prices, companies in the E&P sector tend to be the most important, as their product’s values are directly dependent on oil/gas prices. (See all Energy ETFs here)

SPDR S&P Oil & Gas Exploration & Production ETF (XOP):

Launched in June 19, 2006, XOP is an ETF that seeks investment results corresponding to the S&P Oil & Gas Exploration & Production Select Industry Index. This is an equal-weighted fund consisting of 58 stocks of companies that finds and produces oil and gas, with the top holdings being Chesapeake Energy Corp. (NYSE:CHK), Rice Energy Inc. (RICE) and Devon Energy Corp. (NYSE:DVN). The fund’s expense ratio is 0.35% and pays out a dividend yield of 1.29%. XOP has about $1,811.5 million in assets under management as of Aug 25, 2016.

iShares Dow Jones US Oil & Gas Exploration & Production ETF (IEO):

This fund began in May 1, 2006 and is based on a free-float adjusted market capitalization-weighted index of 54 stocks focused on exploration and production. The top three holdings are ConocoPhillips (NYSE:COP), EOG Resources Inc. (NYSE:EOG) and Phillips 66 (NYSE:PSX). It charges 0.44% in expense ratio, while the yield is 1.47% as of now. IEO has managed to attract $352.5 million in assets under management till Aug 25, 2016.

PowerShares Dynamic Energy Exploration and Production (PXE):

PXE, launched in October 26, 2005, follows the Energy Exploration & Production Intellidex Index. Comprising of stocks of energy exploration and production companies, PXE is made up of 30 securities. Top holdings include Marathon Petroleum Corp. (NYSE:MPC), Pioneer Natural Resources Co. (PXD) and EOG Resources Inc. The fund’s expense ratio is 0.64% and the dividend yield is 7.48%, while it has got $66.5 million in assets under management as of Aug 25, 2016.

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