Direxion’s Daily Energy Bull 3x Shares ETF (ERX) has crushed it this year with a return of 28% to date. What is most noteworthy about this return is that the vast majority of it is grouped in the last month with a 1-month return of 18%. In other words, something just changed in the sector which ERX leverages and market sentiment is now strongly bullish. In this article, I will make the case that the fundamentals for the commodities which ERX’s constituents track are all recently bullish with further bullishness likely to be seen in the coming months, which makes holding ERX a strong play.
Before trading any ETF or ETN, you really need to do some homework to figure out what exactly it is that you’re buying. ERX follows a methodology in which is seeks to give a return equal to three times the daily return of the Energy Select Sector Index. The Energy Select Sector index is an index which gives broad exposure to the energy sector with the vast majority of holdings being in oil and gas production as well as refining. At present, there are 29 holdings but as you can see by the weightings below that most of the concentration of the ETF is in oil and gas production as well as refining.
Since ERX gives us a leveraged exposure to an index which is concentrated around these three related but distinct businesses, we can do a fundamental analysis of the separate lines of businesses to generate an investment thesis as per where ERX is likely to travel in the future.
Oil and Gas Production
The price of oil and gas is without a doubt the most import variable for understanding the earnings of the companies engaged in production (of which nearly the top 50% of ERX’s leveraged holdings represent). Each of these commodities (while often produced in similar locations and fields) have entirely different fundamental drivers which means that if we’re to understand the E&Ps, we need to run an analysis of each commodity.
Let’s start with crude oil in that it makes up the lion’s share of earnings represented by ERX’s holdings. At present, crude oil is bullish. When inventories are seen from a 5-year average standpoint, the reason for a bullish bias can be clearly noted. When inventories draw down at levels faster than the 5-year average, crude prices generally increase.
Over the last month, we have seen one of the largest draws for this season ever seen in crude oil history in North America. This draw has outpaced the 5-year average draw for this time of year as seen in the following chart which compares the trend in changes of stocks versus the trend in the change of 5-year average stocks.
As long as inventories continue to drop at a strong pace (which I believe they will for reasons we will soon discuss), we will see the price of crude increase in step with the relationship seen in the data.
The reason for this draw has been multifaceted in that we have had the variables of supply and demand shift in a perfect storm in which crude runs rose while crude imports fell back below the 5-year average.
The reason why crude runs are increasing is pretty simple – it’s summer driving season and demand (while slightly weaker than average) is seasonally strong. And the reason why crude imports are dropping largely has to do with ongoing OPEC supply cuts coupled with a decrease in imports into PADD 2 (which are mostly Canadian).
ERX rallied strongly during the OPEC meeting and discussions (mid-June / early July) as it became evident that the supply cuts in place for the first half of the year would remain in place for the remainder of the year.
In the April-May timeframe, we saw ERX fall due to crude prices dropping in the face of import rebalancing from Canada (a rebalance which has now run its course so it seems).
Going forward, imports are likely to remain subdued while refining runs are likely to remain more or less a little below average. Production is pretty consistent in that it doesn’t swing as much on a weekly basis so large changes in price over shorter periods of time are likely not to arise from it – but production is likely to continue ticking up throughout the remainder of the year. As long as imports remain weak while demand remains seasonal, we will see bullishness in the price of crude oil and therefore bullishness in the share of ERX.
For natural gas, the picture is pretty straightforward. Gas supply and demand follows a simple pattern: during the summer months, you inject it and the primary demand source is power burn. Power burn depends on the temperatures across the country and temperatures are looking to get hotter than average over the next month with most of the heat concentrated in key demand regions (Gulf Coast / East Coast / West Coast) and the only cooler temperatures seen in low-demand zones.
As this pattern materializes, we’ll see gas inject at slower than normal rates which means that gas prices will likely rise in the immediate future.
Another key component which ERX tracks is refining. For a quick pass at the bulk of the earnings of a refinery, just take a look at gasoline and distillate supply and demand balances because these two commodities represent most of what a refinery produces.
Gasoline has been very turbulent this year but the current message is bullish in that inventories are at the 3rd largest year-to-date draw seen in weekly data as well as stocks will likely fall below the 5-year average in the immediate future.
The two unusually strong drivers of gasoline demand are a decrease in imports coupled with a strong uptick in exports.
When these variables are coupled with the fact that the East Coast just lost a substantial portion of its capacity (which means higher prices are needed to rebalance the market), gasoline is clearly bullish.
Distillate follows a similar story as gasoline in that inventories continue to fall which is indicating higher prices and therefore higher margins for refiners.
It’s hard to make a fundamental case against holding ERX…at least in the short term. ERX is a leveraged ETF which means that long-term holdings probably won’t work out as you expect due to leverage decay. However, if you’ve got the risk tolerance for a medium term play, ERX is currently leveraging a basket of stocks which are sitting on bullish commodities and lines of businesses. It’s a great day to buy ERX.
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.