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Using Leveraged Energy ETFs As Rising Rates Plays

ETF Professor

Turn on CNBC or read news on financial website or blog and chances are you'll see something about how dismal oil prices and energy equities are performing. The Energy Select Sector SPDR (ETF) (NYSE: XLE) confirms as much with a 19 percent year-to-date decline – by far the worst showing among the nine original sector SPDR exchange-traded funds.

Setting Up Contrarian Trades

The Organization of Petroleum Exporting Countries (OPEC) refuses to cut production, a strategy that has helped the United States Oil Fund LP (ETF) (NYSE: USO) to a 44.1 percent year-to-date loss. Even with that, investors keep pouring money into USO and XLE.

Related Link: Think Energy Has More Downside? Here Are Two Ways To Play

Clearly, investments in USO have been the ultimate good money after bad trade, but that also sets oil up to be, perhaps, the ultimate near-term contrarian trade.

With money managers and other professionals barely willing to nibble at oil from the long side, there is little in the way of institutional support for energy stocks and ETFs.

With interest rates poised to rise this month and perhaps several more times next year, it is not unreasonable to expect more downside for energy stocks and potential upside for an ETF such as the Direxion Daily Energy Bear 3X Shares (Direxion Shares Exchange Traded Fund Trust (NYSE: ERY)). ERY attempts to deliver triple the daily inverse performance of the index XLE tracks.

'Energy' Vs. Oil, Natural Gas Stocks

“Investors use energy stocks as somewhat of a proxy for owning oil or natural gas. With oil at its lowest levels since 2008, stocks in the sector are appealing to some value investors because they are beaten down.

“In fact, the price of oil and gas may remain beaten down in a high-interest rate environment. Higher rates raise consumer and business costs, which may reduce their amount of driving, lowers demand for oil, which keeps prices low,” said Direxion .

ERY entered Thursday as Direxion's second best leveraged bearish fund on a month-to-date basis, although traders have pulled money from the fund over the past month, .

Energy And Higher Interest Rates

Interestingly, energy stocks actually perform well in the wake of higher interest rates. In fact, SLE was the best of the nine SPDRs during the Fed's 2004–2006 tightening cycle.

If history repeats, that could bring some much needed relief for the Direxion Daily Energy Bull 3X Shares (Direxion Shares Exchange Traded Fund Trust (NYSE: ERX)).

“Oil prices are already at seven-year lows. World demand is down due to weakness in China and Europe, and Iranian crude has yet to add to the flood of black gold. However, factors such as hurricanes, geopolitical conflict, a change in output from OPEC, and changes in domestic oil production can have counter effects on oil prices, even when rates rise.

“Just when you think you have oil prices figured out, a new factor can come into play. Even the fear of occurrences such as natural disasters and wars can cause oil prices to spike just when they should be dropping,” added Direxion.

Put simply, those that are long ERX and XLE need to see the likes of Exxon Mobil Corporation (NYSE: XOM), Chevron Corporation (NYSE: CVX) and Kinder Morgan Inc (NYSE: KMI) rebound, as those names combine for about 30 percent of XLE's weight.

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