Oil Rally Likely To Continue: ETFs And Stocks To Watch

by: Zacks Funds

Oil prices have shown an impressive rally over the past week on outages and supply disruptions around the world, suggesting that the global oil market might be rebalancing faster than expected. In addition, Goldman (NYSE:GS), one of the most bearish forecasters, gave an added boost by suddenly turning bullish on the commodity.

In fact, oil prices hit a seven-month high, with crude rising to over $48.50 per barrel and Brent currently hovering near $50 per barrel.

Improving Fundamentals

The oil market seems to be rebalancing, with shrinking supply and rising demand. This is especially true as the massive wildfire that broke last week in Fort McMurray, Alberta, is now at the doorstep of the oil-sands mines. This resulted in the evacuation of thousands of workers and cut Canadian oil production by at least 1 million barrels a day. Clearly, this marks a massive reduction given that Canada is the world's fifth-largest oil producer, with an average output of 4.4 million barrels of oil per day.

Additionally, militant attacks and the threat of nationwide strike pushed Nigeria's oil output to a 20-year low of 1.4 million barrels per day. Political instability and economic meltdown in Venezuela also contributed to fears of oil supply disruption. Further, oil production in China fell 5.6% year over year in April and 2.7% in the first four months of 2016, while the U.S. saw a year-over-year decline of 0.7 million barrels a day last month.

Moreover, the U.S. Energy Information Administration (EIA) expects oil production from the seven shale regions - Bakken, Eagle Ford, Haynesville, Marcellus, Niobrara, Permian and Utica - to fall by 113,000 barrels a day to 4.96 million barrels a day in June from May. The agency also predicts global demand to grow on higher Chinese and Indian consumption. It expects demand to rise by 1.4 million barrels per day for this year and 1.5 million barrels per day for the next, compared to the earlier projections of 0.3 million barrels per day and 0.2 million barrels per day, respectively.

Goldman Turns Bullish

The unexpected supply disruption of as much as 3.75 million barrels a day and sustained demand has duly prompted Goldman to turn bullish on oil. The investment bank now believes that the two-year big oil supply glut has taken a "sudden halt" and turned to a deficit. It said "the oil market has shifted from nearing storage saturation to being in deficit much earlier than expected."

As a result, Goldman raised the price target for crude oil to $45 per barrel for the second quarter and $50 per barrel for the second half from $35 per barrel and $45 per barrel, respectively, predicted in March. However, the analyst cautioned that the market would return to surplus in the first half of 2017 on increased exploration and production activity.

Diminishing "Contango" Impact

The spread between the near-term futures contracts and the later-dated contracts has reduced, thereby giving a boost to oil prices. In particular, the spread between the oil futures contracts expiring later this year and similar contracts expiring in late 2018 narrowed to $1.21 from $8 in December 2015. This reduced contango suggests that the supply glut may be falling, after years of overproduction.

If this trend continues to persist going into the peak refining season, the oil market may move into a state of backwardation, where later-dated contracts are cheaper than near-term contracts. This is bullish for the commodity.

ETFs to Tap

While there are several ETFs to play the recent rally in oil prices, we have highlighted three funds each from different zones that are the biggest beneficiaries from this trend.

Oil Futures ETFs - United States Oil ETF (NYSEARCA:USO): This is the most popular and liquid ETF in the oil space, with AUM of $3.9 billion and average daily volume of more than 42 million shares. The fund seeks to match the performance of the spot price of West Texas Intermediate (WTI or U.S. crude). The ETF has 0.45% in expense ratio and gained 8.4% over the past five trading days.

Energy ETFs - PowerShares S&P SmallCap Energy Portfolio ETF (NASDAQ:PSCE): This fund offers exposure to the energy sector of the U.S. small cap segment by tracking the S&P Small Cap 600 Capped Energy Index. Holding 32 securities in its basket, it is highly concentrated on the top three firms with a combined 37.1% share, while other firms hold less than 6.6% of total assets. The fund is less popular and less liquid, with AUM of $52.4 million and average daily volume of about 38,000 shares. The expense ratio came in at 0.29%. PSCE was up about 5% in the same time period (see all the energy ETFs here).

Leveraged Oil ETFs - VelocityShares 3x Long Crude Oil ETN (NYSEARCA:UWTI): This is the popular leveraged fund targeting the energy segment of the commodity market through WTI crude oil futures contracts. It seeks to deliver thrice the returns of the S&P GSCI Crude Oil Index Excess Return and has amassed over $1 billion in its asset base. It trades in heavy volumes of 12.8 million shares a day, though it charges a higher fee of 1.35% per year. UWTI surged 26.4% over the past five trading sessions.

Stocks to Tap

We have chosen three stocks using our Zacks stock screener that have a Zacks Rank #1 (Strong Buy) or #2 (Buy) with a VGM Style Score of "A" or "B". The combination of these two offers the best upside potential.

Murphy USA, Inc. (NYSE:MUSA): This Zacks Rank #1 company is a retailer of gasoline products and convenience store merchandise primarily in the United States. It saw positive earnings estimate revision of 21 cents for fiscal 2016 over the past 60 days and has an expected growth rate of 42.12%. The stock has a VGM Style Score of "A".

Enbridge, Inc. (NYSE:ENB): This Zacks Rank #2 company with a VGM Style Score of "B" is a leader in energy transportation and distribution in North America and internationally. It saw positive earnings estimate revision of 18 cents over the past two months and has an expected growth rate of 8.69% for this year.

McDermott International, Inc. (NYSE:MDR): This Zacks Rank #1 company is a leading provider of integrated engineering, procurement, construction and installation services for offshore and subsea field developments worldwide. It saw an estimate revision to 4 cents from a loss of 3 cents over the past 60 days. It has a VGM Style Score of "B".

Contrarian View

While we expect the oil price rally to continue in the near term, many market experts believe the rise is temporary and that the market will again be flooded with more oil once the problem of outages is resolved. Further, Saudi Arabia and Iran are keen on increasing their output.

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