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Funds: 7 ETFs to Ride a Bullish Oil Cycle Higher -- Barron's

19 May 2018 10:00 am
By Crystal Kim 

Summertime is almost here, and with oil prices spiking, the living looks easy for energy investors.

West Texas Intermediate spot futures, the benchmark for North American oil, have risen nearly 20% so far this year to above $70 per barrel. The recent crude-oil rally has been so impressive, it is finally getting a rise out of oil stocks, pushing the exchange-traded funds that track them sky high. They stand to gain even more if crude prices continue their relentless rise.

That isn't out of the question, despite the recent surge. OPEC's efforts to curb production have worked, reducing the supply glut that took WTI to the mid-$20s in early 2016. In addition, geopolitical issues continue to take barrels off the market, reducing supply even further. Bottlenecks in Texas and New Mexico, in an area known as the Permian Basin, are making it difficult to move oil where it's needed, alleviating fears that U.S. shale production will flood the market.

Basically, all of the pieces are in place for the "most bullish summer for crude in several years," says Michael Tran, RBC Capital Markets' oil analyst.

Now the onus is on investors to pick the right play on crude. Of 65 energy ETFs, 13 hit all-time highs last week, according to Ned Davis Research's ETF strategist Will Geisdorf, who at Barron's request screened its universe of more than 2,100 ETFs for highfliers. The largest that turned up on our screen included Vanguard Energy (ticker: VDE), Energy Select Sector SPDR (XLE), iShares Global Energy (IXC), and iShares U.S. Energy (IYE). "The big integrated [companies] showed up to the party, so Vanguard Energy and Energy Select Sector SPDR appear to be doing well, but we prefer expressing a positive view on crude oil," says Geisdorf. He likes oil-stock ETFs because of crude prices, not because of big-oil-company fundamentals.

Ned Davis Research last month turned positive on the sector, recommending an Overweight on oil stocks. NDR was particularly struck by broad moves, as more than 70% of the energy stocks it tracks broke out above their 200-day moving averages in April, after having lagged behind crude's performance for much of the year. The premise of the recommendation was that they had a lot of catching up to do. Given the firm's bullish view on crude, Geisdorf prefers ETFs with bigger slugs of exploration-and-production companies.

The $3 billion SPDR S&P Oil & Gas Exploration & Production (XOP) and the $1.6 billion VanEck Vectors Oil Services (OIH) fit the bill, he says. The SPDR S&P ETF tracks an index of nearly 70 stocks. More than three-quarters of assets are parked in E&P companies, about 15% in refining, and the rest in integrated oil-and-gas players. The VanEck ETF follows a more concentrated strategy, tracking an index of U.S.-listed companies involved in drilling, services, and equipment. Schlumberger (SLB) and Halliburton (HAL) alone make up nearly a third of the portfolio.

Both of these ETFs have done a good job of tracking oil prices, according to a screen for Barron's by Instinet technical analyst Frank Cappelleri. The VanEck ETF has had a correlation of 65% to crude prices over the past 12 months, while the SPDR S&P ETF has had a 64% correlation.

But if you really want to play high oil prices, bet on oil outright. United States Oil (USO), which tracks oil via futures contracts on West Texas crude, might be the best choice. That isn't always the case, notably when the oil-futures curve is in contango -- that is, longer-dated futures are higher than spot prices, forcing the ETF's custodian to buy high and sell low, swapping maturing futures with further-dated ones. Add to that a fee of 0.77%. The result: USO can decline even on days when crude oil is up, a rude awakening for investors who don't know how derivatives work.

This isn't one of those times. The fund has had a 97% correlation with the price of oil during the past 12 months, according to Cappelleri's data. The ETF's performance can be explained by the futures curve and its move early this year from contango to backwardation, which means longer-dated futures are priced lower than shorter ones. The fund, in short, is selling high and buying low. Note that year-to-date, USO has returned more than 20%, while WTI futures have risen about 18%.

How long do investors have before the futures curve flips the script and USO starts disconnecting from crude prices again? Contango occurs when investors believe that oil prices will fall in the future, and experts don't see signs of that occurring, at least not anytime soon. The biggest risk could be new U.S. pipelines becoming operational in the latter part of 2019, says RBC's Tran, who is otherwise sanguine on the oil market's prospects.

"Major recession concerns, an uninspiring summer driving season, a significant shift in fundamentals over the course of the year -- I'm stretching to come up with scenarios where fundamentals deteriorate," Tran says. "It's unlikely we see contango this year."

So get it while the getting is good. --

email: crystal.kim@barrons.com
 
Scoreboard: http://www.barrons.com/public/page/9_0210-scoreboard.html 

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(END) Dow Jones Newswires

May 19, 2018 06:00 ET (10:00 GMT)

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