We began our Sector ETF investment strategy in late February 2016, which provided some outstanding opportunities to take advantage of a couple of depressed energy ETFs:
- Oil & gas exploration and production
- Oil & gas equipment and services.
Let’s take a look at exploration and production first.
The news was pretty bleak for the oil industry in mid-February, with oil prices reaching a 13-year low of $26.05 per barrel on February 11.
In January, Iran had increased its production to nearly 3 million barrels a day, Iraqi output reached a record high of 4.35 million barrels a day, and shipments from Saudi Arabia also increased.
And we saw the results on the street – gas under $2 per gallon!
However, we have seen all too well in the past that stocks don’t always seem to trend the way we think they should, so let’s see what the data show.
Oil – 1 Year Trend
Back in mid-April 2015, the SPDR S&P Oil & Gas Exploration & Production ETF (XOP) hit its 52-week high of $55.63. Using our methodology, this puts our Buy Threshold just above $41.
In early May 2015, the SPDR S&P Oil & Gas Equipment & Services ETF (XES) reached a 52-week peak of $30.01, putting our Buy Threshold just above $22/share.
Both oil ETFs have been below its threshold since July 2015… so why haven’t we bought them already?
Our answer is that most of the news and fundamentals did not indicate that the sector was going to recover any time soon, so we continued to track the ETF for signs of a bottom.
Overall, the data have trended as expected, continuing level or downward since May 2015 as the oil industry delivered less-than-optimistic news and oil prices continued to slide.
Good News – “The Promise”
On February 17, the Organization of the Petroleum Exporting Countries (OPEC), Saudi Arabia, Russia and other producers agreed to a tentative deal to freeze output.
Experts were quite skeptical of this promise, and as a result the market did not immediately react favorably, especially since oil inventories were still extremely high around the world.
On February 29 support strengthened, resulting in a 3% increase in US oil prices. Saudi Arabia agreed to work with other crude producers to limit market volatility, OPEC pumped less crude than in January, and US producers cut the number of rigs drilling for oil for a tenth week running, taking the rig count to its lowest since December 2009.
Additionally China, the world’s largest oil importer, cut its reserve requirement ratio (the amount of cash banks must hold as reserves) for the fifth time in a year, increasing risk appetite across financial markets.
On the other hand, Iran’s oil exports rose during February, climbing as high as 1.75 million barrels per day, adding to an already oversupplied market. However, financial traders were encouraged by the talks of a global production freeze, signs of falling U.S. shale crude output, and growing gasoline demand.
Taking a look at the XES graph above, which extended a week further than the XOP trend, it’s clear that the sector responded very aggressively to this news – a great sign that this may be an excellent buying opportunity!
So…What’s in Each ETF?
Before committing to a purchase, it’s worth analyzing the distribution of each ETF.
XOP is composed of several oil production companies including household names such as Chevron, Conoco Phillips, and Phillips 66.
Like most of the SPDR ETFs, XOP is an “equal weight” fund, where stocks are weighted equally regardless of company size. This results in no one company exceeding 2.5% of the ETF — a failure or downturn of one or more of the top ETF holdings will not significantly counter the trend of the rest of the ETF’s holdings.
As expected with such a long depression in this sector, most of their fundamentals are not very good with negative earnings per share growth rates, significant increases in short- and long-term debt, and reductions in available cash.
XES is similar, with fundamentals trending downward; however, its major holdings are also well distributed at 4% or less of the entire ETF.
While we invest fully knowing that we’ll never buy at the absolute bottom, both of these ETFs are within the “buy zone” with many signs pointing to a recovery. Furthermore, the volume of shares purchased in both ETFs was at the highest levels in over a year.
At the end of February, we purchased shares of both the XOP and XES ETFs.
The question is, will a recovery continue and, if so, how strong of a recovery will it be and how long will it take?
Note: we also were tracking the Energy Select Sector SPDR ETF (XLE), which bottomed earlier in January, but decided to wait for more positive news and purchased these ETFs instead. In retrospect, XLE would have also been a wise purchase in late January / early February, had there been more signs of an impending recovery to merit additional investments in energy.