Using Energy ETFs to Trade Potential Rise in Oil Prices

Despite the fact that crude oil inventories are high and Americans are driving less, crude oil has been on a tear in recent months. Just four months ago, NYMEX-traded crude oil went for around $30 barrel. Now $70 appears likely, perhaps as soon as this week. Start bracing for a little more pain every time you head to the gas station.

There are five distinct categories of energy-related ETFs and ETNs, namely those that track indexes of:

1. Energy commodities
2. Energy sector equities (diversified)
3. Exploration and production industry
4. Energy services industry
5. Alternative energy industry

Each group has its own advantages and limitations. The ability of ETFs and ETNs to properly track the crude oil price has proven elusive thanks to contango effects in the futures market. Broad-based energy ETFs are heavily weighted in the multinational integrated oil companies. The alternative energy industry consists primarily of companies that don’t rely on crude oil. The exploration and production industry, as its name implies, has historically had a high correlation to crude oil prices.

However, today, we are going to look at another way to play a potential rise in crude oil prices: ETFs focused on the energy services industry. These are the companies that supply drilling rigs, seismic information, logistics, and other related equipment and services to the entire energy sector. Some of the big players include Schlumberger (SLB), Diamond Offshore (DO), National Oilwell Varco (NOV), and Transocean (RIG). The four ETFs that cover this space are:

• SPDR S&P Oil & Gas Equipment & Services ETF (XES) (XES fact sheet) is well-diversified with 26 companies and no holding representing more than 5%. It has an expense ratio of 0.35% and is my favorite member of this group.
• PowerShares Dynamic Oil & Gas Services Portfolio (PXJ) (PXJ overview) is well-diversified with 30 companies but uses a multi-tier weighting system with the top eight holdings receiving higher weighting. It has a net expense ratio of 0.63%.
• HOLDRS Oil Services Trust (OIH) (OIH holdings) continues to enjoy first mover status: it is the heaviest traded and most liquid of the group, although it has below-average diversification with 16 holdings and weightings of RIG at 16.8% and SLB at 11.7%. The HOLDRS structure is dated and has many drawbacks, including the requirement that all trades are in round lots (multiple of 100 shares), but there are no management fees.
• iShares Dow Jones U.S. Oil Equipment & Services (IEZ) (IEZ overview) has 42 holdings yet it is the least diversified of the four with SLB at 21.1% and HAL at 9.2%. It has an expense ratio of 0.48%.

Currently there are no leveraged or inverse products that focus on this industry.

These ETFs have a high positive correlation to oil prices. A positive move in oil usually translates into positive moves for energy service stocks, and that obviously trickles down to the ETFs.

To be sure, these ETFs have been just as hot as oil in recent months. In other words, they could be due for a pullback. The volatility of energy investing can be a lot for investors to handle. But rest assured - oil prices aren’t likely to see the levels they fell to in the latter part of 2008, at least not in the near-term. OPEC is diligently trying to keep prices heading toward $70 a barrel because most of OPEC can’t turn a profit when crude is anywhere below $50 a barrel.

Yes, green is all the rage now. But Wall Street still appears to be a long way off from falling in love with green stocks. Translation: crude oil and related investments won’t escape the market’s eye anytime soon. Using the trend as a guide, it is obvious that the long term trend in oil prices is up.

The charts of the energy service ETFs indicate some possible consolidation in the short-term. A strong move above $70 for crude oil, without a retracement below that level, could certainly tack on some points. XES, PXJ, OIH and IEZ are all comfortably above their 50-day moving averages and recently cleared their 200-day moving averages, despite the negative factors like rising inventories and a drop in consumption. Current prices are back at 2005 levels, before the 2006-2008 run-up in energy. This suggests there is more potential upside in these funds.

Disclosure: no positions

Comments

[Larry House:]

I would rather own two or three of those good names--SLB or RIG or DO, etc. than own an ETF that holds them.

Jun 09 11:52 AM

[RiskReturnO...:]

I prefer XLE with covered calls at $52 strike. Premium alone is 10% gain for waiting things out. As long as crude oil stays above $55, we are fine.

Jun 09 03:31 PM

[isaac the t...:]

OIH has the best volume by far (liquidity) and it does have longterm options out to 2011. So ineffect, there a leveraged product in this space.

Jun 09 04:25 PM

[mr freddo:]

I am going to take a hard look at OIH which I have owned in the past. I think it is a 2 year hold.

Jun 10 01:20 AM

[Trinvester:]

OIH gives you overweighted exposure to the best in class. Good way to play the sector for returns on an upswing and provides relative stability and preservation in a down.

Jun 10 11:18 AM

[Maxe Paul:]

I notice you mentioned there are no leveraged ETF's for oil. That's good because i expect it will all end in tears. Note to big banks, quickly get a 3 x leveraged oil ETF out there for the "masses".

Jun 10 12:37 PM

[SNap33:]

ERX > 3x Bullish & ERY 3x Bearish

Jun 10 02:07 PM

[Ron Rowland:]

Maxe Paul, I think you may have misinterpreted what I intended. When I said "...there are no leveraged or inverse products that focus on this industry." I was refering to the energy services industry, a subset of the energy sector.

There are a large number of inverse and leveraged products for the energy sector and crude oil, but none for the energy services industry. My title for this article is "Energy Service ETFs".
investwithanedge.com/e...

Jun 10 06:56 PM

[Mad Hedge F...:]

Great call! I chatted with Jeff Rubin last night, former chief economist with CIBC World Markets, who reaffirmed my own hyper-bull case for crude in bucketfuls. He was in San Francisco, admiring our civic planning and mass transit system, as part of a tour to promote his new book “Why Your World is About to Get a Whole Lot Smaller: Oil and the End of Globalization.” We are in the bottom of the ninth inning of the hydrocarbon age. The next super spike will take us to over $100/barrel within 12 months of the beginning of an economic recovery, and much higher after that. The problem is that we are losing 4 million barrels/day through depletion just when demand is increasing. The only offset will be dirty, foul, huge carbon footprint, $100/barrel Canadian tar sands, which will double, to account for 40% of our imports. The biggest increase in consumption is in OPEC itself, where consumption has ballooned to 13 million barrel/day and oil is being wasted on a prodigious scale, compared to only 7 million b/d in China. Gas there costs only 25 cents/gal, utilities in Saudi Arabia pay only three cents/gallon for bunker fuel, and Dubai is blowing 3,000 b/d equivalent running an indoor ski resort. Oil over $100/barrel will bring globalization to a screeching halt. Economies will go local because it will cost too much to transport goods, as we have in the past. No more California avocados in Toronto. More importantly, no more Chinese steel in the US, or any other heavy exports, which will lead to a resurgence in domestic manufacturing and the jobs that come with it. Last year $90 of the $600 cost of Chinese steel went to shipping costs. $10/gal gasoline will take 50 million of our 240 million cars off the road. Even if we replace them with electric cars, we don’t have the power grid to juice them. Chinese exports will collapse, but so will their Treasury purchases, meaning no more bailouts for us. Oops. Subprime neighborhoods will get plowed back into farmland so we can eat. I think Jeff is dead on about oil prices. But as necessity is the mother of invention, some of his predictions about their impact on international trade are a bit extreme for me.

Jun 11 10:37 AM