Oil & Gas ETF Investing Guide

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Includes: IEO, PXE, XOP
by: Zacks Funds

Outlook

Crude Oil

U.S. oil futures ended last year 30% below the 2014 level, which itself was 46% below the 2013 level - the first time since the late 1990s of two back-to-back negative growth years. Such was the ferocity of the crash that three of 2015's five worst-performing stocks in the S&P 500 index were all energy companies - Chesapeake Energy Corp. (NYSE:CHK), Southwestern Energy Co. (NYSE:SWN) and Kinder Morgan, Inc. (NYSE:KMI), down approximately 77%, 74% and 63%, respectively. And now, with the failure of a producers' meeting in Doha to agree to a production freeze plan in tackling the supply glut, prices look set to expand their two-year rout.

In recent days, West Texas Intermediate (WTI) crude futures jumped to a seven-month high of $48.31 per barrel on a combination of supply disruptions and a turnaround in the stance of a major investment bank. Oil prices rebounded after Goldman Sachs Group, Inc. (NYSE:GS) said that the market is facing a deficit in crude production following supply disruptions in Nigeria and Canada.

But there are headwinds suggesting that the rally might be short-lived. While some of the production outages might return shortly, the most important factor remains the commodity's oversupply with the glut still very much there.

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 a weak European economy, 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, OPEC members (like Saudi Arabia) have made it clear 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 the medium-to-long term, while global oil demand will be driven by U.S. and the Middle East - this will be more than offset by sluggish growth prospects exhibited by Chinese and the European economies.

In our view, crude prices in the next few months are likely to exhibit a sideways-to-bearish trend, mostly trading in the low-to-mid $40s 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.

Natural Gas

"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 2.681 trillion cubic feet (Tcf) - is up 816 Bcf (44%) from last year and is 813 Bcf (44%) 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 recently dropped to its lowest level in almost 17 years - at $1.611 per million Btu (MMBtu). Apart from plentiful stocks, which hit an all-time high in November, the selloff has been spurred by predictions of 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 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. Also, the past winter - being unseasonably warmer than normal - hampered the heating fuel's demand and keeping inventories at high level.

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 values are directly dependent on oil/gas prices.

SPDR S&P Oil & Gas Exploration & Production ETF (NYSEARCA: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 57 stocks of companies that find and produce oil and gas, with the top holdings being SM Energy Co. (NYSE:SM), Southwestern Energy Co. (SWN) and Continental Resources, Inc. (NYSE:CLR). The fund's expense ratio is 0.35% and pays out a dividend yield of 1.78%.

iShares Dow Jones U.S. Oil & Gas Exploration & Production ETF (NYSEARCA: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 0.43% in expense ratio while the yield is 1.81% as of now.

PowerShares Dynamic Energy Exploration & Production Portfolio ETF (NYSEARCA: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 SM Energy Co., Whiting Petroleum Corp. (NYSE:WLL) and Hess Corp. (NYSE:HES). The fund's expense ratio is 0.64%, and the dividend yield is 2.99%.

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