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Oil & Gas ETF Industry Outlook

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Crude Oil

Posting its second annual gain in a row, oil prices closed 2017 up more than 12%. Keeping up the momentum, the commodity got off to a strong start this year with the West Texas Intermediate (WTI) crude futures climbing 7.1% in January. Though the benchmark tumbled 4.8% in February in the wake of a broad stock market selloff, crude continues to trade above the psychologically important $60 level.

Are the Prices Sustainable?

The sentiment in the oil market has not been this good in years, with U.S. crude prices hitting a more than three-year high of around $66 recently – a spectacular recovery from below $30 in early 2016.

Riding on the positive oil price momentum, the major oil firms like Chevron (CVX), BP plc (BP), Royal Dutch Shell plc (RDS.A) and Total S.A. (TOT) – all part of the ‘Big Oil’ group – recorded massive year-over-year growth in their top and bottom line. Both BP and Shell sports Zacks Rank #2 (Buy), while Chevron and Total carry a Zacks Rank #3 (Hold).

(You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.)

The key question is whether the rally can continue or will these gains be short-lived, having risen too far, too fast.

While it is extremely difficult to predict movements in oil prices, we have identified several drivers that support the commodity’s steadily rising trend. In particular, unlike other short-lived rallies over the past three years, we believe the current higher oil prices are a result of improving fundamentals, as discussed below.

Production Cut Deal Extension:One of the significant reasons why the U.S. oil benchmark soared, revolved around the expansion of the output-cut deal between OPEC and other major producers beyond March. True to predictions, the coalition prolonged the current dynamic for another nine months to the end of 2018.

The agreement, now renewed twice, keeps 1.8 million barrels a day (or 2% of global supply) off the market in an attempt to clear a supply glut. There's no ignoring the fact that the cuts continue to narrow the market imbalances.

Sharp Inventory Drawdowns:Investors have pinned hopes of recovery over the U.S. Energy Department's inventory releases that show multiple weeks of strong inventory draws in the domestic crude stockpiles, pointing to a tightening oil market. Oil stockpiles have shrunk in 35 of the last 48 weeks and are down nearly 110 million barrels since April last year. The gradual fall – stemming from a combination of lower imports and spiraling exports – has helped the U.S. crude market shift from year-over-year storage surplus to a deficit. At 425.9 million barrels, current crude supplies are 19% below the year-ago period.

Specifically, stocks at the Cushing terminal in Oklahoma – the key delivery hub for U.S. crude futures traded on the New York Mercantile Exchange – is down by almost 23 million barrels in the past nine weeks alone.

The Shift into "Backwardation":For most of 2018, the front-month WTI contract has remained in a state of "backwardation" – a phenomenon when near-term oil futures trade at a premium to futures dated further out. Analysts consider this as a bullish signal with the so-called backwardated market helping flush out inventories by eliminating the incentive to put oil in storage.

Booming Exports:Following the lifting of the four-decade long ban on oil exports at the end of 2015, the country witnessed a substantial increase in demand for its oil. While exports ticked up only modestly in 2016, it was last year when the floodgates really opened. Average exports in the first six months of 2017 were around 75,000 barrels per day, which soared to an all-time high of 1.7 million barrels a day during October.

Reflecting the substantial demand for U.S. oil., exports surged in the second half of last year. The disastrous Hurricane Harvey in August knocked out 25% of domestic refining capacity and forced the operators to sell abroad. The widening Brent premium to WTI – as much as $7 after the storm – played its part too. A discount in U.S. oil prices to the global benchmark Brent (or a larger spread) makes domestic crude attractive in overseas markets.

Though exports are expected to retreat a bit from their October highs, we expect levels to remain elevated throughout this year. With U.S. crude trading at a fair discount to international benchmark Brent, American oil remains attractive to foreign buyers. While more shipments might narrow the discount between WTI and Brent, surging U.S. shale output will keep WTI prices in check. Overall, we are unlikely to see the boom in crude exports recede anytime soon.

Favorable Economic Data:The final three months of 2017 saw U.S. GDP grow by 2.6% following gains in the previous two quarters of more than 3%. This marks one of the economy’s strongest stretch of growth since the expansion started in mid-2009. Further, the unemployment rate remained at a 17-year low of 4.1% in February, while U.S. employers added 313,00 jobs last month, the most since mid-2016.

Finally, strong earnings reports from corporate biggies, which has helped support high valuations, boosted sentiments. With American economy remaining on solid footing, the resultant demand growth bodes well for oil prices.

A look back at the Q4 earnings season reflects that earnings for the energy sector recorded a massive 157.2% jump from the same period last year — by far the highest growth among all sectors — on 23.8% higher revenues.

For more information about earnings for this sector and others, please read our Earnings Trends report.

2018 a Pivotal Year for Oil Stocks

While we do not rule out chances for short-term pullbacks on oversupply concerns and a stronger U.S. dollar, we remain extremely confident of an extended period of gains in the near future.

An anticipated surge in demand this year is set to push global consumption above 100 million barrels per day threshold for the first time. However, supply from OPEC – which still accounts for roughly 40% of the world's crude – is expected to remain weak throughout 2018. Also, years of low price environment have forced operators to trim their capital expenditures considerably that means a relatively narrow pipeline of new projects.

To sum it up, though the triple-digit territory of 2014 looks improbable, we expect oil prices to continue to head higher. Also, we are confident that improving fundamentals have probably put a floor under crude prices for the time being.

Natural Gas

Spurred by its cost effectiveness and abundant supply in North America, natural gas – the least harmful fossil fuel compared to coal and oil – is set for a major transformation. The commodity’s long-term demand is expected to soar due to the transition toward a low carbon future and growing usage of natural gas in the Asia-Pacific region.

U.S. Natural Gas Production to Set Record in 2018

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.

On the flip side, the glut has kept prices constrained with demand failing to match supply. As per Energy Information Administration (EIA), the U.S. energy watchdog, the country churned out an estimated 73.6 billion cubic feet (Bcf) per day of dry natural gas on an average in 2017. This year, the level is expected to reach a record 81.7 Bcf per day, outweighing the total forecasted consumption of 78.19 Bcf per day – also an all-time high.      

China: The Main Driver of Natural Gas Demand Growth

Despite domestic supply glut, the fundamentals of natural gas continue to be favorable in the long run, considering the secular shift to the cleaner burning fuel for power generation globally and in the Asia-Pacific region in particular.

The EIA predicts global demand for the commodity to grow from 340 Bcf per day in 2015 to 485 Bcf per day by 2040. Countries in Asia and in the Middle East – led by China’s transition away from coal – will account for most of this increase.

And it will be the world’s largest gas producer U.S., which will step up to meet this soaring demand. With domestic prices struggling to break the $3 per million Btu threshold, U.S. natural gas companies see a big opportunity in selling cheap U.S. production at higher prices to rest of the world. In fact, more than 50% of the domestic volume growth in the near future will be used for export in the form of liquefied natural gas (or LNG). As per Paris-based International Energy Agency (IEA), the United States – which became a net natural gas exporter in 2017 – will vie with Australia and Qatar as the top LNG exporter by 2022.

As of now, Cheniere Energy, Inc. (LNG) is the only company to receive Federal Energy Regulatory Commission approval to export LNG from its 2.6 billion cubic feet per day Sabine Pass terminal in Cameron Parish, Louisiana. But with five LNG facilities likely to begin operations by the end of next year in just the United States, the industry will see a deluge of supply in the short-to-medium term that will take care of the rapid expansion in demand.  

U.S. Exports of LNG to Boost Prices

Overall, long-term fundamentals for the commodity continue to be bullish on the back of structural imbalances. While domestic natural gas production is expected to go up this year, the growing use of LNG, booming exports, replacing coal-fired power plants and higher demand from industrial projects will likely take care of most of the increased output. These secular headwinds will start to have a positive impact on natural gas sentiment with price eventually settling above $3 per MMBtu.

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. In fact, irrespective of the valuation metric used, ‘Energy’ is one of the cheapest sectors to own even as the broader market looks expensive.

The industry currently has a trailing 12-month EV/EBITDA ratio of 6.5, which is lower than the median value of 6.6 over the past year.

Additionally, the reading compares favorably with the market at large, as the current EV/EBITDA for the S&P 500 is at 12.2 and the median level is 11. The industry’s favorable positioning compared to the overall market certainly signals more upside.


Considering the bullish market dynamics of the energy industry, the best 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 gain from higher commodity prices, companies in the E&P sector benefit the most, 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 Jun 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 70 stocks of companies that finds and produces oil and gas, with the top holdings being Anadarko Petroleum Corporation (APC), PDC Energy, Inc. (PDCE) and Noble Energy, Inc. (NBL). The fund’s expense ratio is 0.35% and pays out a dividend yield of 0.82%. XOP has about $2,221.7 million in assets under management as of Mar 13, 2018.

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 65 stocks focused on exploration and production. The top three holdings are ConocoPhillips (COP), EOG Resources, Inc. (EOG) and Valero Energy Corporation (VLO). It charges 0.44% in expense ratio, while the yield is 0.98% as of now. IEO has managed to attract $343 million in assets under management till Mar 13, 2018.

PowerShares Dynamic Energy Exploration and Production (PXE):

PXE, launched in Oct 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 Continental Resources, Inc. (CLR), ConocoPhillips and Valero Energy Corporation. The fund’s expense ratio is 0.8% and the dividend yield is 1.7%, while it has got $46.8 million in assets under management as of Mar 13, 2018.

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