Energy ETFs Contemplate Iraq, Extraction's Shift To Horizontal

Includes: ERX, SCO, SPY
by: Peter F. Way, CFA


The world energy scene is now being disrupted internationally by revolutionary wars and by technological advances. Both imbalance supply and demand, moving prices of ETF investments.

In Europe, ambitions of building more competitive trading units collide with national sovereignty and monetary disciplines. Ukranian alliances disrupt Russian natural gas transmissions, as Crimea becomes its southern seaport.

Development of new natural gas supply sources for Europe threaten Russian markets, making China and the rest of Asia attractive. Disruption of Australia's Asian natgas markets is possible.

World prices for energy fuels are likely to be disrupted by increased sources of supply not under the control of previously dominant major international oil giants. Uncertainties abound.

World energy sources of the past century are undergoing vast, immediate changes

Pursuit and exploitation of large reservoirs, once inexpensively extracted by vertical drilling and entrapped pressures are rapidly being displaced by more economical to find and easier to reach by horizontal drilling and hydraulic fracturing.

Such geological structures are widely found internationally, providing appealing national trade balance realignments, not the least of which is right here in the US. But we are far from being alone.

For the next decade at least, technological expertise in extraction costs and recovery proportions will sort out how oil & gas is recovered, from where and by whom. The old norms are disappearing as costs shift and availability widens.

Overlaid on these economics in transition are political upheavals more due to other influences than to just energy supply and needs. The pervasive involvement of energy in economic development continues to make investments in energy activities a major area of interest. Large opportunities for gains will continue to be presented as varied influences shift.

What do the market-makers [MMs] infer from big-money client trade orders?

A place to look for what is being anticipated by groups that have the money muscle to move prices of investments, is in that concentrated macro-focus investment vehicle, the Exchange Traded Fund, or ETF. There are some 50 or more of these focused on various dimensions of the energy sector.

Energy ETFs hold stocks in natural resource companies providing energy fuels of coal, oil, natural gas; other ETFs focus on the services necessary to provide extraction technologies, to process and transport fuels, and to convert and distribute the energy sources into usable energy forms.

Both sides of the investing proposition are included, some simply benefiting as their holdings' prices rise, others as prices decline. Still other ETFs pursue those paths with gusto by leveraging the price behaviors of holdings by means of structuring via derivative securities.

Many of these ETFs have multi-year daily trading histories which can be tracked in their implied future price change possibilities by the way the big-money-fund clients of the MMs place volume orders (a necessity of their size) that regularly tax the capacity of the everyday market trading resources. In order to fill those orders, the MMs usually must temporarily put their firm's capital at risk to "facilitate the trade."

That is rarely done without buying some kind of hedging protection for the capital. What the MMs will pay at their blockdesk for that protection, what other MMs will charge at their prop-trade desk to supply it, and what the organization at the source of the trade order will accept as a cost of market liquidity, defines by their negotiation, a reasonable, informed opinion of the likely range coming prices for each issue, whether it be an ETF or a holding of the ETF.

This discussion does not delve into the details of why the market-making activity is taking place, which is the perhaps more interesting speculations (for politicians and academics) of what may happen in the international realm. It is concerned with what may happen in the wealth-transferring realm of equity investing.

What are the ETF price-range expectations now?

We perform a standardized, unchanging, logical analysis of the protection costs encountered daily on over 3,000 actively traded and widely-held equity instruments, including several hundred ETFs. That analysis results in a near-term forecast for each of a price range likely to be encountered in the next few months. Records of these forecasts and of subsequent market responses since the turn of this century make up our actuarial resources. Here are the comparative records for Energy ETFs on 6/13/2014:

Click to enlarge

Columns in the above table show the following:

  1. Date of the analysis, Ticker Symbols of the ETFs
  2. Upper end of the Forecast price range derived from market-maker [MM] hedging
  3. Forecast lower end price
  4. Market quote at end of trading on analysis date
  5. Percent change from (4) to (2)
  6. Average of most severe price drawdowns from (4), in sample experiences of (12a)
  7. Metric of % of (2) - (3) price range between (4) and (3)
  8. Percentage of (12a) experiences ending profitably under Time-Efficient Strategy
  9. Average size of net gains among all (12a) experiences
  10. Average holding period of (12a) experiences under Time-Efficient Strategy
  11. Annualized Rate of gain from (9) and (10)
  12. (12a) Number of forecasts like (7) from (12b) past 5 years' days forecasts
  13. Ratio of (9) divided by (5). A forecast credibility test
  14. Ratio of (5) divided by (6). The reward to risk ratio.
  15. [(8) win ODDS x (5)] x [100-(8) loss odds x (6)] all x (12a) prior experiences

The time-efficient strategy referred to simply requires each prior buy of the issue at today's value of (7) to be closed out when reaching or exceeding the sell target of (2), or failing that, after 3 months (63 market days). No interim risk management provisions are involved.

The table is stratified into three sections, where the bottom section ETFs have histories (12b) of less than 3 years (756 market days), the middle section offers upside prospects less than 8% (5), and the top section passes both tests. Each of the three sections are ranked by column (15) a figure of merit measuring the ETF's odds-weighted reward-to-risk balance times the number of instances that such an opportunity has presented itself over the past 3+ years history.

The table includes short-structured ETFs with symbols in red and leveraged long ETFs in bold black.

There are many ways of preferencing investment choices. The one presented in this table stresses wealth-building as its primary mission, using the odds for success or failure from prior forecasts with upside-to-downside balances like that of today.

A simpler picture can be presented where the data from columns (5) and (6) are taken as reward and risk coordinates in an X ~ Y plot map:

(used with permission)

Are both of these saying the same thing, or are they different?

The same data feeds both pictures, the ranked table, and this Reward : Risk Tradeoff map. The map makes it easier for some to visualize the comparisons in an ETF-to-ETF sense. That may make it easier to draw inferences of a broader nature about the energy picture overall.

For example, the map puts higher upside return forecasts and low past downside price drawdown experiences from similar forecasts down and to the right in the green area. At present, the only green-area neighbors (no tenants) are a couple with relatively low-return-outlooks, and far away, right up against the right-field fence of this baseball diamond, are three ETFs. It turns out, when we look at the table, using their number map-identities and symbols, they are all "inverse" ETFs, which go up in ETF price when their equity holdings go down in price.

So the map is telling us that the smart money is negatively impressed by ProShares UltraShort (2x) DJ-UBS Crude Oil ETF (NYSEARCA:SCO)'s underlying index price, crude oil, a measure of the West Texas Intermediate grade [WTI] widely used as a US base price for the commodity. Even so, the large upside forecast for this inverse ETF carries with it large past price declines (column 6) in the ETF market quote in the 3 months following forecasts similar to today's.

We can wonder why major mid-east turmoil that could easily interfere with supply and distribution would not cause US WTI crude prices to rise, as it has at prior points of serious interruption prospects. A rising WTI would logically put SCO's price down, not up. Perhaps the concern over US crude oil prices comes not from abroad, but from rapidly expanding domestic production from the employment of new extractive techniques at lower costs.

Or, on a longer-term horizon, perhaps it reflects a concern over domestic natural gas invading the principal profit market of oil in the US, gasoline. A real concern, since the heat content of $1 of natgas is 5 to 6 times that of gasoline. Think $2 a gallon gasoline (or less)? Fed Express, UPS, and fleet vehicles of various US States are already grabbing such savings.

Just up above SCO on the map is ProShares UltraShort (2x) Oil & Gas ETF (NYSEARCA:DUG), a similar but slightly broader-based inverse ETF. The ranked table has both of these, plus ERY and GASX on its best Odds & Payoffs section, so that short-influence ETFs make up fully half of the best-ranked energy ETFs. They are ranked this way despite double-digit price drawdowns in 3 months or less for all of them. Scary.

The inherent negative bias to price changes in inverse ETFs makes us unwilling to ever use them except in one case where the underlier to the inverse ETF is itself inverse to other equity investment attentions. But that is another story, already told once, to be repeated at another time.

What is different from the map in the table is that the table provides a broader set of comparisons. Besides the details of ETF vs. ETF, we have included the same data line as for each of the Energy ETFs, but for SPDR S&P500 (NYSEARCA:SPY) as a proxy for the equity market overall as viewed by most institutional investment organizations.

That row of data details for SPY reveals that its current forecast is for a price range roughly as much above the current price as below it. That is what its Range Index [RI] of 46 tells: 54% to the upside, 46% to the downside.

Of more interest is the next column to the right, indicating when SPY's RI is 46, 83% of the times (256 of them out of 1261 market days - 5 years) SPY's price in the next 3 months would either reach its forecast range top, or be closed out (by the time limit) at a profit. Odds of a profit in 83 out of every 100 tries is pretty attractive.

Still, the average gain actually reached (in each 100) has been only +2.8%, and the average time to get closed out was 46 market days (out of 63 maximum). Thus the annual rate of gains for SPY is +17%. Not too bad, especially when compared to what the currently top-ranked "8 best" energy ETFs produced from their prior Range Indexes like today's.

The blue average-of-8 row shows that prior RIs averaging 21 (with about 4 times as much upside as downside) scored gains less than half (42 out of 100) of the time, and predictably, came up with a small average net loss of -1.6%. An average that expands to -9% annually.

But if we believe the MMs are well-informed, and we also believe that what is now going on in the mid-east is not at all like the recent past, then perhaps comparing past data results of prior forecast to the current forecast may not be a valid action. Yet, with double-digit downside potentials, more encouragement would be welcome.

What other, less threatening alternatives do we see among energy ETFs?

That second-tier of 19 alternatives with upside forecasts smaller than +8% is already priced high in their collective forecast ranges such that the average RI of the group (77) has three times as much downside as up. Their collective upside forecast of +5% has previously involved them in price drawdowns as bad as -6% on average. On top of that, their typical gains in a time-efficient, disciplined risk-management procedure produces only 3.3% gains, not even the +5% offered.

Individually, the standout in this set is the Direxion Daily Energy Bull (3x) leveraged shares (NYSEARCA:ERX). It has a 7 wins out of every 8 record, achieving slightly more than now being offered (+7.7%) and doing it in little more than 1 month (25 market days), to have created returns at a +115% annual rate. But this record works in a rising market, and we have other indicators putting that notion at risk, so in a fuller context this does not seem a viable alternative by itself.

An intriguing possibility is to couple shorter-term commitments to ERX with comparable commitments to SCO. As long as market pro hedging suggests positive prospects for long positions in both of these ETFs, they may offer a double potential in instruments that logically should move in opposition to one another. Such an approach needs continual supervision. Many other investments in ETFs outside of the energy area may be more promising but they are beyond the scope of this article.


Hopefully this will provide some market price possibility perspectives in an area now in turmoil. Our reaction is to avoid exposure here at this point in time rather than to seek opportunity.

Our whole population of 2542 stocks and ETFs suggests a prospect of individual alternatives likely to present at least a few with more appealing issues involving other than just the energy sector. They will be presented in a separate offering.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.