Exploring E&P ETFs As Earnings Plays

The energy sector is rebounding nicely this year, as highlighted by a year-to-date gain of 6.3 percent for the S&P 500 Energy Index — but better returns can be found in some of the group's subindustries. That includes exploration and production stocks.

Exploration and production stocks and the related exchange traded funds are usually more correlated to oil prices than integrated oil stocks. That is a curse when crude prices fall, but a gift when oil rallies. Crude is one of this year's best-performing commodities, prompting the outperformance by exploration and production ETFs over more traditional energy sector fare.

What Happened

The SPDR S&P Oil & Gas Exploration & Production ETF XOP and the iShares U.S. Oil & Gas Exploration & Production ETF IEO are up 16.8 percent and 14.9 percent, respectively, year-to-date. XOP is an equal-weight ETF while IEO adheres to the more traditional cap-weighted structure.

“The energy sector is expected to post a more than 140-percent increase in earnings per share in the second quarter, a rate of growth more than seven times as strong as that of the S&P 500,” CFRA Research Director of ETF & Mutual Fund Todd Rosenbluth said in a recent note.

“According to CFRA Equity Analyst Stewart Glickman, a major part of the increase is tied to the rise in crude oil prices, as West Texas Intermediate averaged over $68 per barrel in the second quarter, up more than 40 percent versus the year-ago quarter.”

Oil and gas producers, including the companies residing in ETFs such as IEO and XOP, count on crude for about two-thirds of their revenue.

Why It's Important

In the case of XOP, that fund is highly sensitive to oil prices. When oil prices plunged in 2014 and 2015, XOP averaged an annual loss of nearly 34 percent over those two years. IEO and XOP are rallying in significant fashion this year, and the move may have some durability.

“CFRA's fundamental outlook for the oil & gas exploration & production subindustry for the next 12 months is positive, recently raised from neutral,” said Rosenbluth. “Based on S&P Capital IQ consensus estimates, Glickman also sees U.S. E&P companies generating relatively strong production growth in 2018 and 2019, along with modest free cash flow and improved balance sheets.”

What's Next

Traders looking for an adventurous short-term on E&P earnings can consider the Direxion Daily S&P Oil & Gas Exp. & Prod. Bull 3X Shares GUSH, which aims to deliver triple the daily returns of the index XOP tracks.

CFRA has Buy or Strong Buy ratings on 17 E&P stocks and Marketweight ratings on XOP and IEO.

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