A Comprehensive Guide to Oil & Gas ETFs

Oil & Gas Industry Oulook

Crude Oil

The Federal Reserve’s decision to leave its monetary stimulus program intact, together with positive momentum in the domestic manufacturing sector and bullish data from the Chinese economy have strengthened oil prices to 2-year highs of around $110 per barrel.

Partly offsetting this favorable view has been a spike in U.S. production – now at its highest levels since 1989 – and easing Syrian tensions. (Read:Oil ETFs in Focus Ahead of Iran Talks)

The immediate outlook for oil, however, remains positive given the commodity’s constrained supply picture. And, while the Western economies exhibit sluggish growth prospects, global oil consumption is expected to get a boost from sustained strength in China, the Middle East, Central and South America that continue to expand at a healthy rate.

EIA expects global oil demand growth by another 1.1 million barrels per day in 2013 and by a further 1.2 million barrels per day in 2014. Importantly, EIA’s latest report assumes that world supply is likely to go up by 0.8 million barrels per day this year and by 1.2 million barrels per day in 2014. (Read: Play Goldman’s Views with These Commodity ETFs)

In our view, crude prices in the final few months of 2013 are likely to exhibit a sideways-to-bearish trend, trading in the $100-$105 per barrel range.

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. (Read: 2 Ways to Short Natural Gas with ETFs)

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.

As a result, once faced with a looming deficit, natural gas is now available in abundance. In fact, natural gas inventories in underground storage hit an all-time high of 3.929 trillion cubic feet (Tcf) in 2012. The oversupply of natural gas pushed down prices to a 10-year low of $1.82 per million Btu (MMBtu) during late April 2012 (referring to spot prices at the Henry Hub, the benchmark supply point in Louisiana). (See All Energy ETFs Here)

However, things started to look up in 2013. This year, cold winter weather across most parts of the country boosted natural gas demand for space heating by residential/commercial consumers. This, coupled with flat production volumes, meant that the inventory overhang was gone, thereby driving commodity prices to around $4.40 per MMBtu in Apr -- the highest in 21 months.

During the last few weeks, though, natural gas demand has gone through a relatively lean period, as mild weather prevailed over the country, leading to tepid electricity draws to run air conditioners. This led to a slide in the commodity’s price. In fact, healthy injections over last few weeks, plus strong production, have meant that supplies have overturned the deficit over the five-year average.

With more moderate weather expected during the next few weeks, leading to reduced power demand, natural gas prices may experience another downward curve. This, in turn, is expected to pull down natural gas producers, particularly small ones.

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 bull 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 benefit from rising commodity prices, companies in the E&P sector are the best placed, as they will be able to extract more value for their products.

For those interested in taking a non-equity look at energy, we have highlighted a few of the E&P ETFs tracking the industry below, any of which could be interesting picks:

SPDR S&P Oil & Gas Exploration & Production 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 72 stocks of companies that finds and produces oil and gas, with the top holdings being Forest Oil Corp. (FST), Laredo Petroleum Holdings Inc. (LPI) and Magnum Hunter Resources Corp. (MHR). The fund’s expense ratio is 0.35% and pays out a dividend yield of 1.24%. XOP has about $910.9 million in assets under management as of Sep 19, 2013.

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 61 stocks focused on exploration and production. The top three holdings are Occidental Petroleum Corp. (OXY), Anadarko Petroleum Corp. (APC) and EOG Resources Inc. (EOG). It charges 0.46% in expense ratio, while the yield is 0.84% as of now. IEO has managed to attract $448.0 million in assets under management till Sep 19, 2013.

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 30 securities. Top holdings include Noble Energy Inc. (NBL), EOG Resources Inc. and ConocoPhillips (COP). The fund’s expense ratio is 0.65% and the dividend yield is 2.26%, while it has got $85.4 million in assets under management as of Sep 19, 2013.

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