Oil & Gas Industry Oulook

Crude Oil

Record domestic production and the easing of geopolitical fears have combined to keep oil prices below the major psychological threshold of $100 per barrel.

In particular, a spike in U.S. output -- now at their highest levels since 1986 -- has ballooned crude inventories to around 370 million barrels, thereby creating a supply glut. The commodity’s recent lack of momentum also stems from perceptions of easing tensions over Iraqi oil exports. Till now, the militant uprising is limited to the northern part of the country, while Iraq’s production region in the south remains largely unscathed. Concerns about the European economy and the resumption of output from Libya’s largest oilfield have been further weighing on sentiments. (Read: Black days ahead for Coal ETF?)

Partly offsetting this unfavorable view has been a host of largely positive economic data, pointing towards improvement in the U.S. labor market. This has prompted hopes for robust fuel and energy demand in the world’s biggest oil consumer. The bullish momentum has been aided by the Federal Reserve’s measured Taper reduction. The central bank -- asserting that the U.S. economy was strong enough -- trimmed bond repurchases to $25 billion a month in July, substantially down from the peak of $85 billion.

In the medium-to-long term, while the Western economies exhibit sluggish growth prospects, global oil demand is expected to get a boost from sustained strength in China, which continue to expand at a healthy rate despite some moderation. (Read: Ride Transportation Sector growth with this top ranked ETF)

According to the Energy Information Administration (EIA), which provides official energy statistics from the U.S. Government, world crude consumption grew by an estimated 1.3 million barrels per day in 2013 to a record-high level of 90.4 million barrels per day. The agency, in its most recent Short-Term Energy Outlook, said that it expects global oil demand growth by another 1.1 million barrels per day in 2014. But importantly, the EIA’s latest report assumes that world supply is likely to outpace consumption growth and go up by 1.5 million barrels per day in 2014.

In our view, crude prices in the next few months are likely to exhibit a sideways-to-bearish trend, mostly trading in the $90-$100 per barrel range. As North American supply remains strong and the groundbreaking agreement with Iran makes it easier for the country to sell the commodity, we are likely to experience a pressure in the price of a barrel of oil. (Read: 3 Clean energy ETFs for a green portfolio)

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. In fact, natural gas inventories in underground storage hit an all-time high of 3.929 trillion cubic feet (Tcf) in 2012. The oversupply of natural gas pushed down prices to a 10-year low of $1.82 per million Btu (MMBtu) during late April 2012 (referring to spot prices at the Henry Hub, the benchmark supply point in Louisiana).

However, things have started to look up somewhat following a frigid winter that saw the heating fuels’ demand take off. This pushed commodity prices to its highest level in 5 years earlier this year.

But with recent natural gas stock builds continuing to outpace the historical norms on the back of strength in summer production and mild weather, the commodity’s near-term fundamentals remain rather lukewarm, at least till the next heating season starting November.

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 bull 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 benefit from rising commodity prices, companies in the E&P sector are the best placed, as they will be able to extract more value for their products. (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 86 stocks of companies that finds and produces oil and gas, with the top holdings being Green Plains Inc. (GPRE), VAALCO Energy Inc. (EGY) and Emerald Oil Inc. (EOX). The fund’s expense ratio is 0.35% and pays out a dividend yield of 0.66%. XOP has about $1,127.4 million in assets under management as of Aug 27, 2014.

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 76 stocks focused on exploration and production. The top three holdings are ConocoPhillips (COP), EOG Resources Inc. (EOG) and Anadarko Petroleum Corp. (APC). It charges 0.46% in expense ratio, while the yield is 0.83% as of now. IEO has managed to attract $430.7 million in assets under management till Aug 27, 2014.

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 Marathon Oil Corp. (MRO), Marathon Apache Corp. (APA) and Phillips 66 (PSX). The fund’s expense ratio is 0.65% and the dividend yield is 1.72%, while it has got $110.8 million in assets under management as of Aug 27, 2014.

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