Exploring Opportunity With An E&P ETF

Oil was one of 2016's best-performing commodities and that was, predictably, a boon for the energy sector and the relevant exchange-traded funds. The energy sector was the top group in the S&P 500 in 2016; the Energy Select Sector SPDR (ETF) XLE, the largest equity-based energy ETF, surged 28 percent.

Enthused Over Energy

The SPDR S&P Oil & Gas Explore & Prod. (ETF) XOP was even better, easily outpacing XLE and the returns delivered by futures-based oil ETFs with a 2016 gain of just over 38 percent.

As an exploration and production ETF, XOP is often more levered to fluctuations in oil prices than a more diversified fund like XLE. That strategy has its risks and rewards, but in what could be a good sign for XOP, U.S. shale drillers appear comfortable betting that higher prices are on the way.

“In a bullish sign, oil producers are preparing for rising prices. The US oil rig count has steadily increased from 316 rigs at the end of May to nearly 500 rigs as of mid-December,” said State Street Vice President David Mazza in a recent note.

Interest Rates And Sector Cyclicality

Higher interest rates can benefit cyclical sectors and energy, the seventh-largest sector weight in the S&P 500, is a cyclical group. XOP is an equal-weight ETF so none of its 63 holdings dominate the lineup, in turn reducing single stock risk. Still, the weighted average market value of $24.4 billion for XOP's holdings is smaller compared to a traditional energy ETF like XLE.

“XOP seeks to track the S&P Oil & Gas Exploration & Production Select Industry Index, which comprises oil producers whose operations and revenue streams are highly dependent on oil prices. In the past five years, this index has had a 0.74 beta sensitivity to the spot price of oil vs. a 0.11 beta for the S&P 500 Index,” added Mazza.

While XOP emphasizes exploration and production stocks, refiners and integrated oil names combine for nearly 23 percent of the ETF's weight.

“Holdings 1 through 15 of the market cap-weighted Dow Jones U.S. Select Oil Exploration & Production Index account for 73 percent of the entire index. However, the same holdings in the equal-weighted S&P Oil & Gas Exploration & Production Select Industry Index account for only 35 percent of the index — providing a far less concentrated portfolio,” noted Mazza.