Well, that party sure ended with a thud. The spectacular run enjoyed by many energy exchange-traded funds (ETFs) in the past year has taken a different turn. Specifically, I'm talking about funds that track oil equities. Part of the move higher was certainly attributable to the Federal Reserve's second round of quantitative easing. The expectation that the U.S. would get its act together and emerging market economies would continue to show rising oil demand factored into the equation as well.
Oil stocks and the ETFs that hold them have fallen on hard times recently. Quantitative easing has ended, at least for the moment. U.S. economic indicators are weak, and that may be putting it mildly. With the world's largest oil consumer staring at reduced GDP growth forecasts, oil prices could continue suffering in the near-term.
Speaking of reduced growth forecasts, the reality of slower growth is setting in emerging markets such as China and India, pressuring oil equities in the process. [See David Sterman's "How "the China Shock" Could Affect Your Portfolio -- and How to Prepare Now"] None of this sounds like good news, but trust me, there is a silver lining and it is this: There are suddenly a fair amount of equity-based oil ETFs trading well off their 2011 highs. For investors that can handle oil's inevitable near-term gyrations, some of these ETFs could prove very rewarding down the road. On the bright side, there is almost no getting around the fact that the long-term demand picture for oil shows an upward slope. Whether or not you believe in peak oil, the fact is demand is rising while production is declining across the globe. That means higher oil prices.
Here are a few ETFs that merit consideration...
1) iShares Dow Jones US Oil Equipment IEZ)
Companies like Halliburton (NYSE: HAL), National Oilwell Varco (NYSE: NOV)and other IEZ constituents make the equipment and provide the services essential to everything from deep-water drilling in the Gulf of Mexico to "fracking" in shale oil fields throughout the world. In era of increased safety protocols for offshore drillers and the need to tap unconventional deposits such as shale plays, oil services stocks and ETFs offer attractive growth prospects.
In the case of IEZ, it would be foolish to ignore the fact that its price chart is not going to win any beauty pageants as it currently looks. It took roughly one month for IEZ to fall from nearly $70 to the low $50s. However, the devil is in the details, and the devil might be saying something positive regarding IEZ.
Earlier this month, National Oilwell Varco, IEZ's third-largest holding, announced $1.5 billion in new Brazilian contracts. Halliburton, IEZ's second-largest holding, followed that up on Aug. 25 by saying it plans to add 11,000 employees this year. A massive payroll addition like that doesn't happen unless is a company is optimistic in its long-term outlook.
While XOP doesn't offer extensive exposure to oil services names, its chart bears an unfortunate, yet striking resemblance to IEZ's. In addition, this ETF has a few caveats that must be noted before getting involved. First, XOP is one of the more volatile equity ETFs in an already volatile group. Second, XOP is consistently one of the most heavily-shorted ETFs in the United States. In fact, its short interest usually far exceeds the ETF's total shares outstanding.
3) JPMorgan Alerian MLP AMJ)
AMJ is a play on the toll-road concept of master limited partnerships (MLPs). MLPs basically ensure that oil and gas moves from Point "A" to Point "B" -- and those commodities have to move from the field regardless of price. So companies such as Enterprise Products (NYSE: EPD), Kinder Morgan (NYSE: KMP) and Plains All American Pipeline (NYSE: PAA), AMJ's top three holdings, are not as beholden to oil and natural gas prices as exploration and production companies.
AMJ should help investors reduce beta, which is a measure of volatility relative to the overall market. But MLPs have not been entirely immune to the recent downturn in the energy patch. That said, MLPs have been less bad than traditional exploration and production and services stocks during the past month. AMJ currently sports a yield of about 5.4% and is almost 12% off its 52-week high, so there might be some value to be had as well.
Risk to Consider: A prolonged slump for the global economy would suppress oil demand and prices, in turn weighing on shares of XOP. In the event of another recession, oil prices could fall far enough that producers would scuttle or delay drilling projects. This scenario would adversely impact IEZ.
Action to Take--> This trio of ETFs has a little something for everyone. For those looking for the best potential for capital appreciation in the back half of 2011, go with IEZ. The shale boom and increased safety measures for offshore drillers are two major catalysts for services providers, but those games are still in the early innings, so XOP might not have as much near-term juice as IEZ.
AMJ can be paired with either of the other two funds as a yield play and beta reducer within a portfolio or it can stand alone as a dividend holding for conservative investors. In the case of XOP, the fund's high risk/high reward nature is nothing if not interesting, but wait for this one to confirm a legitimate move higher before pulling the trigger.