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What Lies Ahead for Oil & Gas ETFs?

Which market sector outperformed all others in 2016? Knowing which sector has been hot could point to where you should invest in 2017.


Investors looking for the ‘strongest performer’ for the U.S. stock market's price action last year need look no further than stocks in the energy sector. Yes, you heard it right.


With a market-thumping 24% return, 'Energy' was the top performing S&P sector in 2016 proving that oil is indeed alive and kicking. (Read: Oil at Pre-OPEC Level—ETFs to Benefit)


The Year 2016 in Review:


Oil's 2016 journey was marked by sudden sharp sell-offs followed by swift recoveries. However, with crude's wild ride, we saw some big winners — and big losers as well. So essentially, investors with good stock-picking skills made a lot of money, while those who bet on the wrong stocks got absolutely hammered.


By February, prices plunged all the way to a low of $26 per barrel, thanks to the boom in shale oil production and rising output from OPEC. The dramatic slide prompted several analysts to make bold calls on a potential bottom. While some suggested prices might drop as low as $20 a barrel, gloomier estimates called for a sensational $10-per-barrel floor.


But thankfully, none of these bone-chilling forecasts were correct. (Read: Output Cut to be Extended? Leveraged Energy ETFs in Play)


A historic OPEC production cut agreement, together with help from non-OPEC producers and slashing investments (in existing and new wells) saw oil prices more than double from their February lows to end the year around $54.


The Recent Sell-Off:


For the first couple of months of 2017, oil prices found themselves locked in a sideways trading range, as the tug-of-war over two powerful, opposing supply narratives continued.


Reports indicated an impressive 90% compliance level from the OPEC producers who pledged output cuts in an effort to tackle the three-year supply glut. However, a burgeoning rig count – pointing to the ever-increasing shale drilling activities – kept prices under check and within a band between $50-$55 a barrel.


And then prices broke below the psychologically important $50 threshold after U.S. government data showed that supplies – building since the beginning of the year – rose to record levels amid an increase in production.


At over 535 million barrels, current crude supplies are up 7% from the year-ago period and are at the highest level since the EIA began keeping records in 1982. Moreover, domestic output has steadily risen to more than 9 million barrels per day, the most since February 2016.


In fact, oil’s recent troubles have made ExxonMobil Corp. (XOM) and Chevron Corp. (CVX) the two worst Dow performers so far this year – down 8% and 7%, respectively.


Energy Roadmap for 2017:


Despite hope offered by the biggest oil deal in a decade and a new pro-fossil fuel administration in the White House, investors would be mistaken if they expect oil to double again in 2017.


As of now, the commodity has erased most of the gains since OPEC announced output cuts in November, notwithstanding speculation that the cartel members could exercise an option to extend its pact by another 6 months to the end of 2017.


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.


As is being witnessed, the recent uptick in U.S. shale production has put more pressure into the market.


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.


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.


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 Slumped to 17-Year Lows in 2016 and then Recovered:


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.


Only to Fall Again This Year:


Unfortunately, selling has come back to the market since then. Year-to-date, natural gas has performed the worst among major commodities. It dived more than 35% through late February and while prices have rebounded somewhat in March, they are still struggling to stay above $3 for a prolonged period.


With the winter heating season – which runs from Nov 1 to Mar 31 – coming to an end and the injection season set to start, fundamentals point to 'lower for longer' prices. Agreed, this year there is around 17% less natural gas in storage compared to the year-ago period, but worryingly, the current stock is 15% more than the five-year average for this time of the year.


A warmer winter translated into weaker demand for the heating fuel and upended demand forecasts. And now, as March comes to a close, one would expect tepid demand for the commodity with spring-like weather expected over most parts of the nation in the upcoming weeks.


The depressed pricing environment weighed on natural gas drillers like QEP Resources Inc. (QEP), Southwestern Energy Co. (SWN) and Chesapeake Energy Corp. (CHK), which slid 33%, 21% and 11%, respectively year-to-date.


Our View: More Upside for Both Oil & Gas


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.


By the onset of summer months, these secular headwinds will start to have a positive impact on natural gas sentiment and price.


Valuation also Signals More 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 8.45, which is lower than the median value of 9.48 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 10.85 and the median level is 9.96. The industry’s favorable positioning compared to the overall market certainly signals more upside.




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 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 Chesapeake Energy Corp., Rice Energy Inc. (RICE) and Callon Petroleum Co. (CPE). The fund’s expense ratio is 0.35% and pays out a dividend yield of 0.81%. XOP has about $2,441.1 million in assets under management as of Apr 6, 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 55 stocks focused on exploration and production. The top three holdings are ConocoPhillips (COP), EOG Resources Inc. (EOG) and Phillips 66 (PSX). It charges 0.44% in expense ratio, while the yield is 0.97% as of now. IEO has managed to attract $418.4 million in assets under management till Apr 6, 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 30 securities. Top holdings include ConocoPhillips, Pioneer Natural Resources Co. (PXD) and EOG Resources Inc. The fund’s expense ratio is 0.75% and the dividend yield is 6.85%, while it has got $58.5 million in assets under management as of Apr 6, 2017.


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