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Q4 Outlook for Oil & Gas ETFs

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OIL & GAS OUTLOOK

Crude Oil

The free fall in oil prices have made 'energy' the most talked-about sector of the entire market in 2015, apart from the fact that its performance has been the worst. Year-to-date, 'The Energy Select Sector SPDR' has posted a loss of 20%. On the other hand, the broad-based Dow Jones Industrial Average and the S&P 500 index shed just 8% and 5%, respectively, over the same period.

As of now, crude prices are trading just above the key psychological level of $40-a-barrel after hitting a new 6-1/2 year low of $37.75 recently. This, despite a short spike that saw the commodity scale a year-high of $61.43 per barrel in June. (Read: 4 Ways to Short the Energy Sector with ETFs )

Oil is facing the heat on several fronts. Perhaps, the most important of them pertains to the mounting worries about China's crude demand. In particular, the Asian giant's currency devaluation has stoked speculation about soft economic growth in the world's No. 2 energy consumer.

What's more, in the absence of production cuts from OPEC, the effects of booming shale supplies in North America and a stagnant European economy, not much upside is expected in oil prices in the near term. Moreover, a stronger dollar has made the greenback-priced crude more expensive for investors holding foreign currency. The Iranian nuclear framework agreement, which has the potential to release more of the commodity in the already oversupplied market, has put the final nail in the coffin.

As it is, with inventories near the highest level during this time of the year in 80 years at least, crude is very well stocked. On top of that, OPEC members (like Saudi Arabia) have made it clear time and again that they are more intent on preserving market share rather than attempting to arrest the price decline through production cuts. Therefore, the commodity is likely to maintain its low trajectory throughout 2015. (Read: Still Believe in Goldman's $20 Oil, Go Short with These ETFs )

This has forced the oil companies and associated service providers to make deep cost cuts by reducing their workforce. Oilfield services behemoths like Halliburton Co. (HAL), Schlumberger Ltd. (SLB) and Weatherford International plc (WFT) were the first to respond to the worsening situation, announcing substantial redundancies earlier in the year. Of late, they have been joined by integrated majors including Royal Dutch Shell plc (RDS.A) and Chevron Corp. (CVX).

In the medium-to-long term, while global oil demand will be driven by China - which continues to be the main catalyst to liquids consumption growth despite the current slowdown - this will be more than offset by sluggish growth prospects exhibited by Asian and the European economies.

In our view, crude prices in the next few months are likely to exhibit a sideways-to-bearish trend, mostly trading in the $40-$50 per barrel range. As North American supply remains strong and demand looks underwhelming, we are likely to experience a pressure in the price of a barrel of oil.

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.

Statistically speaking, the current storage level - at 3.261 trillion cubic feet (Tcf) - is up 473 Bcf (17%) from last year and is 127 Bcf (4%) above the five-year average. Expectedly, this has taken a toll on prices. Natural gas peaked at about $13.50 per million British thermal units (MMBtu) in 2008 but fell to sub-$2 level in 2012 - the lowest in a decade.

Though it has recovered somewhat, at around $2.70 now, the commodity is still way off the heights reached seven years back. In fact, natural gas been trading range bound over the last couple of quarters with investors looking for direction. It has been stuck between $2.50 and $3 per MMBtu over the past 5 months.

In response to continued weak natural gas prices , major U.S. producers like Chesapeake Energy Corp. (CHK), Cabot Oil & Gas Corp. (COG) and Range Resources Corp. (RRC) have all taken significant cost-cutting measures, including a reduction in their capital expenditure budgets for the year.

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 have been held back. Even the summer cooling demand has been of little help. What's more, with improved drilling productivity offsetting the historic decline in rig count, and expectations of tepid heating demand with the imminent arrival of soft late-summer temperature, we do not expect gas prices to rally anytime soon.

PLAYING THE SECTOR THROUGH ETFs

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 73 stocks of companies that finds and produces oil and gas, with the top holdings being HollyFrontier Corp. (HFC), Tesoro Corp. (TSO) and PBF Energy Inc. (PBF). The fund's expense ratio is 0.35% and pays out a dividend yield of 1.98%. XOP has about $1,472.9 million in assets under management as of Sep 10, 2015.

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 74 stocks focused on exploration and production. The top three holdings are ConocoPhillips (COP), Phillips 66 (PSX) and EOG Resources Inc. (EOG). It charges 0.45% in expense ratio, while the yield is 1.77% as of now. IEO has managed to attract $403.5 million in assets under management till Sep 10, 2015.

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 Phillips 66, Valero Energy Corp. (VLO) and Marathon Petroleum Corp. (MPC). The fund's expense ratio is 0.64% and the dividend yield is 2.20%, while it has got $92.9 million in assets under management as of Sep 10, 2015.

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SPDR-SP O&G EXP (XOP): ETF Research Reports

ISHARS-US O&G (IEO): ETF Research Reports

PWRSH-DYN ENRG (PXE): ETF Research Reports

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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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