Oil & Gas ETF Industry Outlook

Crude Oil

Last year, 'Energy' was the strongest S&P sector performer with a market-thumping 24% return. In particular, November's historic OPEC-led production cut deal to alleviate a supple glut managed to buoy oil prices and stabilize them around the psychologically important $50 per barrel threshold. The commodity was on a stellar run on optimism surrounding the agreement, and the outlook for oil stocks was getting better.

The seemingly positive developments encouraged investors to bet on firming prices for 2017 with the oil industry finally hoping that 'this would be the year'. True to the strong sentiments, U.S. oil prices reached around $55 per barrel in late February, the highest level in 19 months.

However, the situation is drastically different now, with the commodity having floundered in recent weeks. By June 21, crude had cratered more than 20% from its February highs and officially plunging into bear territory. In fact, prices ended down 14.3% for the first half of the year – the worst performance since 1998. Therefore, it was not surprising that ExxonMobil Corp. (NYSE:XOM) and Chevron Corp. (NYSE:CVX) – the DJIA’s two energy giants – were among the 7 Dow stocks that closed the first half with a loss. Both the scrips experienced sharp declines in price this year, when the index (with a rise of 8%) marked its best first half performance since 2013.

Apparently, there was one small thing that the bullish speculators didn’t account for – the spectacular boom in U.S. shale production. Arguably, the biggest development in global oil markets over the last few years, the relentless increase in North American shale output has undermined efforts by OPEC and other major producers’ efforts to ‘rebalance’ the market and prop up prices.

Supply Side Woes Plague Oil Market

Apart from the much-discussed shale production issue, there are some other reasons as well why oil markets remain oversupplied. (Read: Energy to Drive Q2 Earnings--Will ETFs Rebound?)

At the crux of the matter is the rising flood of U.S. shale-driven production. Now at a financial equilibrium, the shale firms are putting more rigs and employees back to work. Throughout the downturn, producers worked tirelessly to cut costs down to a bare minimum and look for innovative ways to churn out more oil from rock. And they managed to do just that by improving drilling techniques.

With these efforts, many upstream companies have repositioned themselves to adapt to the new $50 oil reality and even thrive at those prices. In other words, while OPEC's moves to trim output and rebalance the demand-supply situation has stabilized the market to a large extent, in the process it has incentivized shale drillers to churn out more. As per EIA's latest inventory release, crude production over the last 4 weeks averaged about 9.42 million barrels per day, up 11% from the same 4-week period last year.

The extension of supply curbs by top producers led by OPEC also disappointed markets. At a meeting in Vienna in May, the cartel (plus non-members led by Russia) decided to roll over their output cuts of 1.8 million barrels per day (bpd) to reduce global oil inventories until Mar 2018. The move, though widely expected, spooked some oil market investors who hoped that the cuts would be deepened/lengthened further.

Meanwhile, the producer cartel pumped more oil last month than in June – the third successive monthly rise in 2017 – on increasing output from Nigeria and Libya, which are exempt from the deal. The production boost offset improved compliance by other members. (Read: 5 Reasons to Buy Bank ETFs Despite Low Rates)

OPEC Fails to Curb Oil Glut

It’s quite clearly evident that the output-cap agreement spearheaded by OPEC has failed to achieve its stated goal of bringing global crude stockpiles down to five-year averages. Even the various energy-monitoring bodies – EIA, IEA, and OPEC – have of late projected that U.S. crude production will continue to ramp up through 2018, thereby leading to slower-than-expected market rebalancing.

To sum it up, oil’s future direction will depend on the battle between the OPEC-led output cuts and the increase in U.S. shale production. But as of now, it seems that the ‘lower for longer’ oil is there to stay well into next year.

A Rebound on the Cards?

Some analysts believe that oil prices have bottomed out following the recent selloff. While a significant rebound is out of question due to the lingering supply-demand imbalance, one could expect some short-term price gains.

Investors have pinned hopes of recovery over the recent U.S. Energy Department's inventory releases that show multiple weeks of strong inventory draws in the domestic crude and gasoline stockpiles – pointing to a slowdown in shale output.

The nation's oil stockpiles have shrunk in 16 of the last eighteen weeks. This has helped the U.S. crude market shift from year-over-year storage surplus to a deficit. Gasoline stocks have also been going down. As a result of recent decreases, the existing stock of the most widely used petroleum product has now fallen 1.8% below the year-earlier level.

It’s this comprehensive decline in oil and product inventories the energy traders have been waiting to see all this while. (Read: 3 Reasons to Buy Gold ETFs Now)

Even as we cannot run down the chances of the market moving sideways and seeing high volatility, many analysts are not too bearish about oil in the remainder of 2017.

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.

Prices Bottomed Out in 2016 Followed by One of the Strongest Rises:

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 hit 17-year lows of around $1.6 per million British thermal units (MMBtu) in the first quarter of 2016. The glut was further exacerbated by lackluster industrial requirement.

Thereafter, successive below-average builds on the back of warmer temperature across the country cut into the year-over-year storage surplus. And nine months later, the commodity made a dramatic turnaround. Natural gas ended 2016 within touching distance of $4 per MMBtu - an annual gain of 59.4%, the best in 11 years. This was also aided by slowing output from shale basins amid a December cold blast that stoked heating demand. No wonder, producers like Rice Energy Inc. (RICE), WPX Energy Inc. (WPX) and Encana Corp. (ECA) saw their shares jump more than 100% last year.

Only to Drift Lower Again This Year:

Unfortunately, selling has come back to the market since then. During the first six months of 2017, natural gas was one of the worst performing major commodities with a loss of about 18%, still struggling to stay above $3 for a prolonged period.

Agreed, this year there is around 9% less natural gas in storage compared to the year-ago period, but worryingly, the current stock is 6% more than the five-year average for this time of the year. A warmer winter translated into lower average power burn for the heating fuel and upended demand forecasts.

And now, with the summer injection season (Apr to Oct) turning out to be warm but not scorching enough across major U.S. pockets, demand for natural gas to fire power plants for running air conditioners is expected to be fairly tepid. To make things worse, supply has started to pick up on the back of accelerated drilling, while the startup of Cheniere Energy Inc.'s (LNG) Sabine Pass export terminal on the Gulf coast has opened foreign markets to surging domestic supplies.

Finally, a lack of major storm landfalls in the heart of the hurricane season in the U.S. means we are unlikely to see any near-term spike in prices due to production disruptions. Therefore, barring a sustained spell of blistering temperatures, analysts see gas prices trading near $3 per MMBtu this summer.

Our View: Oil & Gas Prices to be Range Bound

Oil:In our view, crude prices in the next few months are likely to exhibit a sideways-to-bullish trend, mostly trading in the $45-$55 per barrel range. Even as North American shale supply remains strong, oil will be supported by the continued tightening of world oil markets through OPEC curbs and improved global demand outlook.

But this does not mean that we will not see any short-term pullbacks. On the whole, we expect oil prices in 2017 to be higher than 2016 levels, but remain significantly below the $100-per-barrel at which oil traded prior to the commodities slump that started in July 2014.

Natural Gas:Long-term fundamentals for the commodity continue to be bullish on the back of structural imbalances. While domestic natural gas production is expected to rebound this year, the growing use of liquefied natural gas (or LNG), booming exports to Mexico, replacing coal-fired power plants and higher demand from industrial projects will likely take care of the increased output. The resulting effect will ensure natural gas storage keeping pace with the 5-year average in the near future, with deficits piling up later on.

Over the summer, these secular headwinds will start to have a positive impact on natural gas sentiment with price eventually settling above $3.

Valuation Signals Some Upside

Going by the EV-to-EBITDA (enterprise value to earnings before interest, tax, depreciation and amortization) ratio, which is often used to value oil and gas stocks, given their significant debt levels and high depreciation and amortization expenses, the industry doesn’t look expensive at this point.

The industry currently has a trailing 12-month EV/EBITDA ratio of 7.00, which is lower than the median value of 8.59 over the past 1 year.

Additionally, the reading compares favorably with the market at large, as the current EV/EBITDA for the S&P 500 is at 10.53 and the median level is 10.45. The industry’s favorable positioning compared to the overall market certainly signals more upside.

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’s values are directly dependent on oil/gas prices. (See all Energy ETFs here)

SPDR S&P Oil & Gas Exploration & Production (MX:XOP) ETF (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 64 stocks of companies that finds and produces oil and gas, with the top holdings being Rice Energy Inc., HollyFrontier Corp. (HFC) and EQT Corp. (NYSE:EQT). The fund’s expense ratio is 0.35% and pays out a dividend yield of 1.00%. XOP has about $2,119.2 million in assets under management as of Aug 10, 2017.

iShares Dow Jones US Oil & Gas Exploration & Production ETF (IEO):

This fund began in May 1, 2006 and is based on a free-float adjusted market capitalization-weighted index of 56 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 0.44% in expense ratio, while the yield is 1.12% as of now. IEO has managed to attract $362.5 million in assets under management till Aug 10, 2017.

PowerShares Dynamic Energy Exploration and Production (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 29 securities. Top holdings include Delek US Logistics Inc. (DK),Phillips 66 and Valero Energy Corp. (NYSE:VLO) The fund’s expense ratio is 0.50% and the dividend yield is 2.38%, while it has got $46.3 million in assets under management as of Aug 10, 2017.

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