Crude Back To $40: Can Energy ETFs Sustain Their Rally?

|
Includes: FCG, FXN, PSCE, XOP
by: Zacks Funds

After seesawing between losses and gains, U.S. crude is back to the $40 per barrel mark. In fact, price has jumped over 53% from their 12-year lows in mid February. The furious rally was driven by several factors that are pointing to a rebalancing of the oil market and infusing optimism among investors.

The first and foremost reason is the hope that major producers will cut an output freeze deal next month. If the deal is sealed, it would be the first between OPEC and non-OPEC producers in 15 years to stabilize the oil market and will definitely lower the supply glut. Secondly, falling U.S. and Organization of the Petroleum Exporting Countries (OPEC) production helped in lifting sentiments. As per the U.S. Energy Information Administration (EIA), oil production is expected to decline from 9.4 million barrels per day in 2015 to 8.7 million barrels per day in 2016 and to 8.2 million barrels per day in 2017.

Also, smaller crude stockpile builds and higher gasoline consumption in the U.S. gave a further boost to the energy space. Though crude inventories climbed for the fifth straight week by 1.3 million barrels, it is smaller than market expectations. Notably, gasoline demand rose 6.4% year over year over the past one month. Moreover, the dovish signal from the Fed in its latest meeting has pushed the U.S. dollar to five-month lows, making oil cheaper for foreign investors.

The combination of all these factors has increased the appeal for oil and other commodities, fueling a rally in the energy space.

Outperforming ETFs

While almost all energy ETFs have seen smooth trading with the recent oil price surge, the PowerShares S&P SmallCap Energy Portfolio ETF (NASDAQ:PSCE) is leading the space, having surged about 33% over the past four weeks. This was followed by the SPDR S&P Oil & Gas Exploration & Production ETF (NYSEARCA:XOP), the First Trust Energy AlphaDEX ETF (NYSEARCA:FXN) and the First Trust ISE-Revere Natural Gas Index ETF (NYSEARCA:FCG) that gained 29.6%, 28.2% and 26.8%, respectively, in the same time period.

Below, we profile these ETFs in detail and discuss some of the specifics behind their recent rally:

PSCE

This fund provides exposure to the energy sector of the U.S. small cap segment by tracking the S&P Small Cap 600 Capped Energy Index. Holding 33 securities in its basket, it is highly concentrated on the top two firms that make up for a combined 26.2% share. Other firms hold less than 7.2% of total assets. The fund is less popular and less liquid with AUM of $42.4 million and average daily volume of about 32,000 shares. The expense ratio came in at 0.29%.

XOP

This fund provides equal weight exposure to 64 firms by tracking the S&P Oil & Gas Exploration & Production Select Industry Index. Each holding makes up for less than 2.9% of the total assets. XOP is one of the largest and popular funds in the energy space with AUM of over $2 billion and an expense ratio of 0.35%. It trades in heavy volume of around 18.1 million shares a day on average.

FXN

This follows an AlphaDEX methodology and ranks stocks in the broad energy space by various growth and value factors, eliminating the bottom ranked 25% of the stocks. This approach results in a basket of 61 stocks with none holding more than 3.62% of assets. It has managed $486.4 million in its asset base and trades in volume of 527,000 shares per day on average. It charges a higher 64 bps in annual fees.

FCG

This fund offers exposure to the U.S. stocks that derive a substantial portion of their revenues from the exploration and production of natural gas. It follows the ISE-REVERE Natural Gas Index and holds 40 stocks in its basket that are well spread out across each component with none holding more than 6.38% of the assets. The fund has amassed $203.1 million in its asset base while charging 60 bps in annual fees. Volume is good with more than 3 million shares exchanged per day on average.

What Lies Ahead?

Given the optimism and signs that the oil market may begin to tighten, risk-tolerant, long-term investors could consider energy ETFs for the short term, provided they have the patience for extreme volatility. However, the outlook for the sector looks quite bleak given that the oil market is still oversupplied. While the U.S. producers have started to reduce output and OPEC is looking to freeze production at January levels, Iran is trying to ramp up its production after the international sanctions on it were lifted in January.

Additionally, even if the deal to freeze oil output at January's level is reached, the world will still have about 300 million excess barrels per year than needed. This is because the major countries produced oil at their record levels in January. Thus, it would be difficult to rebalance the oil market at least in the short term.

Further, the three products out of the four detailed above have a bottom Zacks Rank of '4' (Sell) or '5' (Strong Sell), suggesting that these will underperform the market in the coming months. Meanwhile, FCG has a Zacks ETF Rank of 3 (Hold).

Original Post