NYSEARCA:IYE offers investors exposure to the U.S. energy market, including many of the big oil companies responsible for a large portion of the global energy supply chain. This fund is ideal for investors looking to implement a sector rotation strategy or even for those looking to be overweight in the U.S. energy sector.
Like most domestic energy ETFs, IYE has significant exposure to a few select names in the sector, making up most of its entire portfolio.
2020 was a turbulent year for energy commodities, especially for oil. We saw crude prices fall more than 65% from their 2020 starting levels. 2019 did not paint a pretty picture either for the commodity as prices remained low despite decreased production levels by the Organization of the Petroleum Exporting Countries (“OPEC”) and reduced capacity given the geopolitical tensions in the Middle East.
To add to its woes, oil demand remained weak amid lower global growth expectations arising from the trade dispute between the U.S. and China, the world’s largest oil consumers.
The start of 2020 saw the energy markets witness a double whammy as prices dropped to $12/barrel in March, the lowest in over two decades. On the supply side, a disagreement between Saudi Arabia and Russia, the world’s second and third-largest oil producers, respectively, increased expectations for increased oil production. On the demand side, the global pandemic led to an economic slowdown globally, which saw businesses close and travel restricted, reducing the crude demand by airlines and industries.
The significant drop in demand for fuel by various sectors meant that production exceeded storage capacity, which even led to some WTI Crude Futures contracts trading under zero briefly in April 2020.
Oil and gas companies, which are usually heavily leveraged, found it challenging to carry out operations as credit downgrades soared and defaults become commonplace. Many oil majors altered their capex spending programs and considered stock buyback programs instead.
As oil continued to drop below profitability levels, oil and gas exploration and production companies scaled back their drilling operations and lowered production estimates.
The turnaround for oil came in May, once governments began to reopen their economies slowly and as clinical trials for a vaccine picked up the pace. This optimism continued for the rest of the year, with oil reaching its pre-pandemic levels by the start of 2021.
Eventually, over the last year, IYE was positive, recording price appreciation of 16%, underperforming the broader market.
Constituent Holdings
IYE’s largest allocation is to integrated oil & gas companies like Exxon Mobil (XOM) and Chevron (CVX), which together make up close to 43% of IYE’s portfolio. Another 22.8% is allocated to companies engaged in oil and gas exploration and production companies. IYE covers the entire spectrum of the supply chain and offers investors exposure to ancillary industries in the sector, such as equipment and storage providers and oil and gas transportation companies.
IYE’s top 10 holdings together constitute 73.76% of the entire fund. The weighting assigned to these top 10 holdings is illustrated in the table below.
Source: Seeking Alpha
Outlook for Oil Going Forward
The prospects for the oil and gas industry have improved drastically over the last few months. From the lows of $10 seen in April 2020, crude prices have climbed to pre-pandemic levels of $60/barrel at the timing of this writing. This rally in prices can be attributed to the reduced supply and increased demand for the commodity due to global economies' gradual reopening. Furthermore, the rollout of stimulus packages by major economies added to the momentum.
OPEC's actions and its allies, mainly the group’s leading crude oil exporter Saudi Arabia and Russia, will continue to influence oil prices. The group has been keeping a lid on supplies while Saudi Arabia is making additional voluntary production cuts of a million BPD to help prop up prices.
As per a report published by S&P Pratt Global Analytics, global oil demand is expected to increase by more than 6 million b/d in 2021 (compared with 2020) and return to 2019 levels despite the sharp acceleration of COVID infections lockdowns authorized by many nations. Continued production cuts by OPEC and the broader availability of vaccines are expected to drive oil demand in 2021.
What are the Risks to be Considered?
Energy sector risk: The performance of energy stocks may decline for various reasons such as changes in energy prices, shifting energy supply and demand dynamics, and government regulations. Given that IYE is purely focused on the oil and gas sector, this poses a significant sectoral risk.
Non-diversification risk: Given that IYE invests close to 74% of its assets in its top 10 holdings, any adverse impact on these companies' business could negatively affect the ETF as a whole.
The Bottom Line
An increase in oil prices improves the outlook for all of IYE’s portfolio companies. Given that IYE’s allocation is tilted towards oil producers and exploration companies, the rise in oil prices will immensely benefit these holdings.
IYE’s top three holdings, Exxon, Chevron, and ConocoPhillips (COP), have been hit the hardest with reduced revenues and quarterly losses as oil fell below the profitability levels of $40/barrel. Now with prices significantly above this mark, we can expect these companies to become profitable once again. A gradual uptick in industrial activity and the transportation sector will also help to support oil prices around current levels soon.
We all are aware that Green energy and sustainable energy sources are the future. Therefore, it would be prudent for oil and gas companies to fund research in this area. However, these green energy technologies are still evolving, and until then, we will continue to see sustained demand for oil and gas products. As such, investors can look at IYE to gather exposure to the sector.
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