Diversified Downstream Energy: A Hedged Synthetic ETF Strategy

| About: Energy Select (XLE)

Summary

Best Broad Exposure to Refiners by Long XLE / Short XOP.

Liquidity Issues with Direct Refinery CRAK ETF.

Using VXX as a Hedge During Rocky Oil Markets.

By Daoyi Wu

Strategy Examined:

  • Long XLE (Energy Select Sector SPDR ETF);
  • Short XOP (SPDR S&P Oil & Gas Exploration & Production ETF);
  • (Optionally Hedged with Long S&P 500 VIX Short-Term Futures Index TR VXX)
  • Tickers Referenced: XLE, XOP, CRAK, VXX, HYG, JNK, VDE, IYE

Recommendation

Two recommendations are being made: 1) Long XLE and short XOP when oil price bounces back. 2) Long VXX using limit orders, used as hedging for the first recommendation.

Fundamental Assumptions

  1. Oil price has a large probability of trading around $30 if not lower for a long period of time.
  2. Large energy companies would outperform small energy companies. Downstream companies would outperform upstream companies.
  3. Default of oil companies would start a panic on high yield bond market.
  4. Another sell off in high yield bond would increase stock market volatility.

Crude oil prices bounced back above $30 after hitting $27 in January. However, we still hold the idea that bear is in control of the market and oil trading around $30 or lower has a large probability. We see no clear sign of a significant oil cut. Recently, Nigeria has asked for $3.5bn in emergency loans to fill a growing gap in its budgets, and many other small oil export companies struggling as oil prices are tumbling. Though they have been declining for 18 months, oil and other energy commodities might just start to shape the whole industry. As exhibit 1 shows, US oil companies have an average cost of about $40. It's reasonable to bet that large energy companies would outperform small energy companies and downstream companies would outperform upstream companies if oil stays at $25 - $40 range.

Click to enlarge

Exhibit 1: Oil Cost Curve (via FinancialSense)

We could use XLE and XOP to express this view. XLE put more weight into oil & gas refining, marketing and services while XOP put more weight into oil exploration and production. XLE is a market cap weight ETF and XOP is an equal weight ETF, meaning XLE put larger weight in large oil companies.

Why not simply directly invest in Market Vectors Oil Refiners ETF (NYSEARCA:CRAK) rather than taking a long and short position to synthesize diversified exposure within downstream energy? There are several reasons. The first is expenses. CRAK's expense ratio (0.59%) is higher than the combined expense ratio of XLE and XOP. Liquidity is an even bigger concern. CRAK trades only 10,000 shares daily while XLE and XOP both trade millions of shares daily. Average bid-ask spreads for CRAK are higher as well. The CRAK ETF has only traded since August 2015, but it appears as though demand for trading is not relatively high. Of course, investors must consider short selling constraints (costs and capabilities) when evaluating these two alternatives. Any institutional investor with low short selling and overall trading costs will find it difficult to execute a refiner strategy using the CRAK ETF given its limited liquidity.

Key Statistics of CRAK (as of 2/12/2016)

Net Assets

$3.76M

Price Per Share

$17.45

Fund Manager

VanEck

52-Week Range

$17.01 - $20.88

Asset Class

Equity Energy

# of Holdings

26

Weighting Type

Market-cap

Beta

0.65

Alternatives

XLE-XOP

Average Spread

0.38%

Average Volume

10,283

Premium/Discount

Listing Exchange

NYSEArca

Dividend Yield

0.527%

Expense Ratio

0.59%

Click to enlarge

Sources: ETF.com, VanEck website, Analyst Calculations

Turning back to the XLE-XOP strategy, exhibit 2 shows price difference of two ETFs and XLE/XOP ratio, proving the fundamental idea. One could argue that profit potential is very limited, but we expect XLE would continue to outperform XOP if oil price stays around $30. Investors can consider building position when oil goes up higher and XLE/XOP ratio drops to 2 or lower. Compared to simply holding positions of oil ETFs, holding XLE and XOP has several benefits. First it wouldn't necessarily lose money if the oil price is mildly trending up as small energy companies might still struggle. Second, same reasoning for small energy companies, the trade would still make money if oil just stays at $30 levels. The payoff of the trade would be asymmetric.

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Exhibit 2: USO, XLE/XOP & XLE-XOP

Losses would occur if the oil market changes to bull, and we might also suffer from our long XLE position if XLE top holding energy companies default or even bankrupt. That's when VXX and JNK come into play as an insurance. Exhibit 3 shows high yield spreads in the past 20 years, and the present 7.5% is already at a very high level. Of course, one could argue that the collapse of high yield bond is due to commodities prices and that we have no reason to worry about rest of the high yield bond world excluding energy sectors. That's partially true in our opinion. The fall of commodity price is definitely the major cause, but the collapse of high yield bond would be a lot faster than investors could imagine when liquidity becomes a problem. Exhibit 4 shows 60 day rolling correlation of USO and JNK, it suggests that the high yield bond market would deteriorate if oil price keeps sliding down.

The most direct way is to short JNK. However, one major problem of shorting JNK is that high yield bond market is already at the lowest level since 2008, it would be very costly to short it. Another problem is that we would have to short a large number of shares as JNK has a very small volatility. A better way to limit the risks is to buy VXX at a low price. It's reasonable to assume that default or bankruptcy of energy sectors would lead to a sell off of high yield bond market and eventually lead to increasing volatility of equity. VXX itself is very volatile and therefore one would only need to take small position at low price. Another benefit of using VXX is that as the correlation of oil market and US equity market has surged to 0.9, one could cover some loss from XLE-XOP if oil suddenly surges. Of course one could also short JNK as a supplement if it bounces back to a high level and we have a strong belief it would collapse again. A simple comparison of JNK and HYG is presented in next part.

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Exhibit 3: BofA Merrill Lynch US High Yield Master II Option-Adjusted Spread

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Exhibit 4: USO & JNK 60 Day Rolling Correlation

XLE, XOP and VXX Key Statistics

XLE Key Statistics (as of 2/2/2016)

Net Assets

11.33 bil

Price Per Share

55.33

Fund Manager

SSgA

52-Week Range

$49.93 - $83.66

Asset Class

Equity Energy

# of Holdings

40

Weighting Type

Market-cap

Beta

0.98

Alternatives

VED, IYE

Average Spread

0.02%

Averaging Volume

18.9 mil

Premium/Discount

0.13%

Listing Exchange

NYSEArca

Dividend Yield

3.57%

Expense Ratio

0.14%

Click to enlarge

Key Statistics of XOP (as of 2/2/2016)

Net Assets

1.79 bil

Price Per Share

26.33

Fund Manager

SSgA

52-Week Range

22.06-56.18

Asset Class

Equity Energy

# of Holdings

60

Weighting Type

Equal-weighted

Beta

1.15

Alternatives

IEO

Average Spread

0.04%

Averaging Volume

12.0 mil

Premium/Discount

0.07%

Listing Exchange

NYSEArca

Dividend Yield

2.46%

Expense Ratio

0.35%

Click to enlarge

VXX Key Statistics (as of 2/2/2016)

Net Assets

632.3 mil

Price Per Share

25.4

Fund Manager

Barclays Capital

52-Week Range

15.48-37.35

Asset Class

Volatility

# of Holdings

2

Averaging Volume

60.0 mil

Beta

-4.18

Listing Exchange

NYSEArca

Average Spread

0.05%

Expense Ratio

0.89%

Premium/Discount

0.11%

Click to enlarge

Sources: ETF.com, VanEck website, Analyst Calculations

Exhibit 5 & 6 show XLE and XOP top 10 holdings performance in 2015. Small energy companies had much worse performances.

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Exhibit 5: XLE top 10 holdings Exhibit 6: XOP top 10 holdings

Source: Financial Times

Recent Performance

Click to enlarge

Source: Yahoo! Finance

Comparison to Alternatives

XLE and VED have similar expense ratio and IYE's expense is much higher. XLE is the largest ETF among three with 11.50bn USD. XLE is a better choice because it has more liquidity and it has outperformed VDE in the past 3 years.

Symbol

XLE

VDE

IYE

Price

55.33

75.79

30.89

3-year total return

-3.26%

-4.54%

-4.05%

3-year standard deviation

17.82%

18.49%

18.17%

Net expense ratio

0.14%

0.10%

0.43%

Total net assets

11.50bn USD

3.72bn USD

1.01bn USD

Daily Volume

18.9 mil

548,116

1.2 mil

Click to enlarge

Sources: ETF.com

XOP is an equal weighted ETF and there is no similar smart beta ETF currently available. XOP has large AUM, low expense ratio and bid-spread, and high daily trading volume, providing sufficient liquidity.

The most popular high yield bond ETFs are HYG and JNK. Two ETFs have similar size, expense ratio and liquidity. One should consider JNK if one wants to short the market because it has a worse performance compared to HYG. Exhibit 7 shows that JNK is of lower quality than HYG.

% Bonds

Type

JNK

HYG

AAA

0

0.81

AA

0

0

A

0

0

BBB

0.81

1.26

BB

39.72

49.73

B

44.89

38.59

Below B

14.58

9.6

Not Rated

0

0

Click to enlarge

Exhibit 7: JNK & HYG Credit Breakdown, Source; ETF.com

Recommendation Details

XLE closed at $55.33, XOP closed at $26.37 and VXX closed at $25.40 on Feb. 2nd. The price difference between XLE and XOP is at $28.96. If one expects more rumors of oil cuts will be floating around, consider taking the trade when crude oil price hit $35 or XLE/XOP ratio drops to 2 or lower as it provides a better risk reward ratio. One can consider the use of limit buy orders to gradually take long position when VXX drops below $20.

The following are recommended to use as stop loss levels:

1) As $40 stands an important resistance level in technical chart, consider using oil breaking $40 as a stop loss level.

2) Price relationship between XLE and XOP breaks down regardless of oil trending down.

Size Positioning: Consider a position of $1 XLE and $0.2 VXX long position and $1 XOP short position.

Risks of the trade

The following graph provides an intuitive way how this trade might perform under different situations. One would take a loss if oil price keeps rising, but that is a manageable risk if one is tracking oil prices regularly.

Oil Price

High Yield Bond

Equity Market

Equity Volatility

XLE-XOP

VXX

Total

Rise sharply

Rise

Rise Sharply

Rise

Loss

Profit

Breakeven

Rise slowly

Rise

Rise

Drop

Loss

Loss

Loss

Flat

-

-

Drop

Profit

Loss

Breakeven or Small Profit

Drop slowly

Drop

Drop

-

Profit

-

Profit

Drop sharply

Drop Sharply

Drop Sharply

Rise

Profit

Large Profit

Large Profit

Click to enlarge

There are other risk factors one should closely monitor as they would change whole fundamental assumptions:

  1. Oil cut deal or geopolitical events that would significantly shift long term prospect of oil.
  2. Monetary easing in US.
  3. Clear signs of improving global economies.
  4. Breaking news of XLE top holdings.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This article provides opinions and information, but does not contain recommendations or personal investment advice to any specific person for any particular purpose. Do your own research or obtain suitable personal advice. You are responsible for your own investment decisions.