After two years as one of the worst-performing segments of the U.S. equity market, the energy sector roared back with a vengeance last year to rank as one of 2016’s best-performing sectors. The Energy Select Sector SPDR (ETF) (NYSEARCA:XLE), the largest exchange-traded fund tracking the S&P 500’s seventh-largest sector weight, surged 28% as oil was one of the year’s top commodities.
While last year’s boffo performances by energy stocks and ETFs could be seen as a sign that the sector is set to cool off, there are indications some energy-related securities can keep climbing. For example, earnings gloom associated with energy stocks over the past couple of years is ebbing.
In fact, recent data from AltaVista Research indicate that the energy sector is no longer the earnings drag on the S&P 500 that was in 2015 and for part of last year.
Bolstering the case for energy ETFs and energy stocks is the fact that, in an aging bull market, energy is one of a small number of sectors that can be considered a legitimate value destination. In fact, on a forward-looking basis, energy stocks are downright cheap.
Efforts by the Organization of Petroleum Exporting Countries (OPEC) and other major oil-producing nations, such as Russia, to trim production could support oil prices this year. That combined with compelling valuations and rebounding earnings could make the following energy ETFs alluring.
Energy ETFs to Buy: iShares U.S Oil & Gas Exploration & Production ETF (IEO)
Expense Ratio: 0.44% per year, or $44 on a $10,000 investment
Among energy ETFs, exploration and production funds are usually highly leveraged to oil prices, meaning these funds can be more volatile than standard energy ETFs, which are usually heavily allocated to more docile integrated oil stocks. The iShares Dow Jones US Oil & Gas Exp.(ETF) (NYSEARCA:IEO) has a three-year standard deviation of almost 26% compared to 19.7% on the comparable diversified energy ETF, according to iShares data.
Another way of looking at the landscape for energy ETFs such as IEO is that demand and production dynamics play an important part in charting the course for this type of energy ETF. The good news is that supply is starting to tighten and there are some incremental signs of increasing global oil demand.
What could throw a wrench in that scenario is a boost in output by U.S. shale drillers. Those companies slashed output when oil prices were low amid earnings and credit concerns, but with prices rebounding, those companies may look to ratchet up output to make up for lost time.
Energy ETFs to Buy: Global X MLP ETF (MLPA)
Expense Ratio: 0.45%.
When it comes to energy stocks, the conventional wisdom used to be that master limited partnerships (MLPs) were not as exposed to oil prices as E&P or integrated names. MLPs were previously seen as a safe way to generate income among energy stocks, and the asset class was embraced for its high-yield “toll collector” status.
The most recent oil bear market repudiated that theory as MLP ETFs such as Global X FundsF (NYSEARCA:MLPA) swooned alongside traditional energy ETFs. But now MLPA is on the mend, and the dividend yield of over 7.1% is hard to ignore for many income investors.
“Since the period of heightened volatility in early 2016, volatility has stabilized at just below 20%, two-thirds lower than the peak of MLP market volatility. Volatility has remained under 20% for the past two months. West Texas Intermediate crude prices increased last month, up 8.66% to $54/barrel. In addition, correlations between MLPs and other asset classes fell considerably as investors weighed the ramifications of the late-November OPEC agreement. We have found that when oil prices rise, correlations between MLPs and crude decrease,” according to recent Global X research.
While MLPA’s expense ratio is well below that of actively managed MLP funds, potential investors should consult their tax professionals about the tax implications about holding an energy ETF of this nature in their portfolios.
Energy ETFs to Buy: Elkhorn S&P MidCap Energy Portfolio (XE)
Expense Ratio: 0.29%.
For the investor who does not want the risk and volatility that can come along with small-cap energy stocks but is looking for something more exotic than large- and mega-cap energy fare, there is finally a mid-cap energy ETF. The Elkhorn S&P MidCap Energy Portfolio (BATS:XE) is part of a nine-ETF suite of mid-cap sector ETFs launched by Elkhorn last month.
XE tracks the S&P MidCap 400 Capped Energy Index, which can be seen as the mid-cap equivalent of the index linked to the aforementioned XLE.
Home to 20 stocks, XE is not heavily allocated to traditional integrated energy stocks, as most of those companies dwell in the large-cap space. It does feature significant refining exposure, which can be a plus if oil prices retreat because refining margins can be squeezed as crude prices rise.
At the time of this writing, Todd Shriber did not own any of the aforementioned securities.