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How ETF Investors Can Play An Oil Rally After OPEC Deal Raises Hopes

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It may be too early for ETF investors to give a clean bill of health to the oil market and energy sector, but it seems fair enough to describe them as on the mend. Some recent developments suggest the stars may be aligning on their side.

First came the shock election win for Donald Trump, who has championed homegrown energy production and scoffed at the concept of climate change brought about by fossil fuels. Some investing strategists also took note in November of rising bond yields to express a preference for value sectors, including energy.

Then on Wednesday, in a move that surprised many, the Organization of the Petroleum Exporting Countries (OPEC) agreed to cut production for the first time in eight years.

Without such a deal, traders were eyeing oil in the $30s . Now, one oil bug is expecting prices between $45 and $55 for the next three to six months.

"It's a good sign," said John Love, president and CEO of United States Commodity Funds, which runs United States Oil ( USO ). "It puts a floor (under prices) and I don't see us dropping below $40."

Love expects more volatility ahead for oil as the markets digest the OPEC news and normalize. USO spiked nearly 9% Wednesday after major oil producers agreed to slash output by 4.5% from current levels.

Oil extended gains on Thursday, with U.S. crude breaking well above $50 a barrel, a key level.

Any positive news for oil must be considered under the shadow of a massive global supply glut, Love wrote in September, when global inventory stood at nearly 3.1 billion barrels.

But if the OPEC deal helps to bring supply and demand into alignment, and oil continues to rally, there could be opportunities aplenty for investors in exchange traded products.

Here are five areas that could benefit:

  • Diversified energy funds . Of more than two dozen exchange traded funds holding energy equities, $4.27 billion Vanguard Energy ( VDE ) is cheapest. Its 0.10% expense ratio translates to $10 in annual fees for every $10,000 invested.

[ibdchart symbol="VDE" type="daily" size="quarter" position="leftchart" ]

It's a cap-weighted fund whose 133 stock holdings include several small- and midcap names. But it's dominated by top holdings Exxon Mobil ( XOM ) and Chevron ( CVX ), which account for a combined third of portfolio assets.

VDE advanced 9.8% in November to take year-to-date gains to 26.7%. It has seen net outflow to the tune of $191.6 million in 2016 so far, while Energy Select Sector SPDR ( XLE ), a heavily traded rival focused on S&P 500 stocks, absorbed $1.90 billion.

Both funds set new highs Thursday but are trading well under their 2014 highs.

The OPEC decision provides a positive catalyst for oil prices and energy stocks, Dave Mazza, head of research for SPDR ETFs told IBD via email.

That's in part because energy stocks are sensitive to the price of oil. Integrated oil and gas companies like Exxon and "upstream" companies, for whom oil is an input cost, generally get hurt by falling prices.

"While valuations appeared relatively attractive for some time, less negative quarter-over-quarter earnings in the third quarter highlighted that investors may have gotten too bearish on energy stocks," Mazza added.

Mazza and Love both noted continuing risks, with non-OPEC producers still not cutting crude oil output, and higher prices likely to bring U.S. shale players back into the market.

  • Niche energy funds . The best way to play an oil rally may lie outside the biggest and most broad-based ETFs that target the energy sector.

Mazza particularly likes the outlook for oil and gas drillers, or those focused on the exploration and production (E&P) sector.

These companies can be found in niche energy equity ETFs such as PowerShares S&P SmallCap Energy (PSCE), SPDR S&P Oil & Gas Equipment & Services (XES), SPDR S&P Oil & Gas Exploration & Production (XOP), VanEck Vectors Oil Services (OIH) and iShares U.S. Oil Equipment & Services (IEZ).

Their top holdings include Transocean (RIG), Diamond Offshore Drilling (DO) and Marathon Petroleum (MPC).

PSCE, XES and XOP jumped more than 12% Wednesday, more than double the gains XLE saw that day.

"XOP and XES include an allocation to small- and midcap stocks that XLE does not, and have had a higher beta sensitivity to oil prices," Mazza said.

Expect higher volatility as the trade-off for potentially tastier returns with these funds, and higher expense ratios to boot.

Analytics firm CFRA upgraded its view on the oil and gas E&P sector to neutral on Wednesday.

  • Natural resources funds . Looking beyond energy equities to a natural resources fund may help investors seize additional opportunities for portfolio diversification and potential growth.

SPDR S&P Global Natural Resources (GNR) invests in metals and mining, agriculture and energy. Its holdings includes companies involved in forest-based products, such as paper, containers and packaging.

"Natural resources stocks have been shown to have a strong connection to break-even rates, which have soared postelection," Mazza said.

GNR, with $800.9 million in assets, is up 28.3% year to date.

Some pros at investing in ETFs share that positive outlook for this sector. In fact, Amy Magnotta, a senior investment manager at Brinker Capital, has added exposure to natural resources equities after the Nov. 8 election.

Expecting a reflationary trend, the $18 billion investment management firm recently reallocated client portfolios to dial up equity risk and is now overweight equities.

"Today we prefer more diversified natural resources exposure (over energy)," Magnotta told IBD in a phone interview. She is gaining that exposure with Victory Global Natural Resources (RSNRX), an actively managed mutual fund, and has used iShares North American Natural Resources (IGE) in the past.

Their holdings should benefit from higher inflation and energy infrastructure spending, she added.

IBD'S TAKE:OPEC's announcement sent shale stocks soaring, see which shale plays are now buys .

  • Other sector and industry funds. Other industries that could profit from higher oil prices and their exposure to the energy sector include engineering, construction, machinery and equipment rental, said Todd Rosenbluth, director of funds research at CFRA.

The tiny First Trust ISE Global Construction & Engineering (FLM) is a pure-play ETF for exposure to these industries.

Industrial Select Sector SPDR (XLI), Vanguard Industrials (VIS) and Guggenheim S&P 500 Equal Weight Industrials (RGI) have big stakes in these companies too.

Financial Select Sector SPDR (XLF), iShares U.S. Financials (IYF) and their sector peers also stand to gain from a brighter energy outlook. Many of their holdings, especially smaller regional banks in oil-rich parts of the U.S., are exposed to energy loans.

On the other hand, airlines, for whom oil is a key cost, could get hurt by higher energy prices, Rosenbluth added. U.S. Global Jets (JETS) has slipped since Wednesday. But it remains near a new high after running up 10% from a buy point in a cup-with-handle base.

  • Commodity funds . The $3.35 billion United States Oil ( USO ), run by Love's firm, tracks the price of oil by holding futures contracts. That makes it a great tool for traders and sophisticated investors - but not for novices.

Basically, the fund won't give long-term holders the same returns as the spot price of oil. This year, there have been periods when oil was up 21%, but USO was down 6% .

In a phone interview with IBD on Wednesday, Love noted that the front of the futures curve is still in contango - meaning each subsequent month on the "curve" is priced higher than preceding months.

Over time, that adds to roll costs and acts as a drag on returns.

Another option is a broad-based fund such as $2.36 billion PowerShares DB Commodity Tracking (DBC).

DBC has up to a 60% stake in energy, but also includes metal and agricultural commodities. It invests across 14 sectors, enhancing the diversification benefits that commodities bring to traditional stock-and-bond portfolios.

The fund follows a rules-based approach, to minimize the effect of contango, and caps exposure to energy at 60%.

Year to date through November, DBC has gained 13.9% while USO has lost 0.6%.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.


The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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