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Feb 29, 2024

Insights From ETFs: A Contrarian Approach to the Oil Sector

by Michael Huynh

Oil prices have been under tremendous pressure recently due to the expected declining oil demand driven by weak global economic activities. Consequently, share prices of oil companies in general are experiencing negative momentum, while their fundamentals remain sound, making it worthwhile to revisit the investment in oil sector.

Why oil now?

With crude oil prices in the range of $70, most of the oil companies are generating record cash flow. This is due to the breakthroughs in oil drilling techniques such as horizontal drilling techniques in recent years. This innovation has allowed oil companies to access previously untapped reserves, which has improved the efficiency of every dollar of capital investment that oil companies put into rigs.

Moreover, the majority of earnings are returned to shareholders through increasing dividends and buybacks. Financially, most oil companies are currently in great shape compared to previous cycles, making them more resilient than ever in a cyclical downturn.

Not many people can predict oil prices with a high degree of confidence over time. However, given the recent policies of the Organization of Petroleum Exporting Countries (OPEC) and other large oil-producing countries regarding oil production cuts to reduce supply, we think oil prices will stabilize in the near-term. If that is the case, the recent drawdown could turn out to be a great time to get exposure to the sector at a reasonable valuation. 

When it comes to the oil industry, there is a famous quote about the cyclicality of the business: ìThe cure for low oil prices is low oil pricesî. For a cyclical sector like oil, investors should be prepared to act with a contrarian approach.

Long-term oil prices

Investment in oil companies is a long-term bet on oil prices. In spite of near-term volatility, there are a few reasons why oil prices could be favourable over the next few years. 

Supply and demand mismatch

Oil companies historically over-invest in good times, and cut back capital investment meaningfully in bad times, leading to a high degree of cyclicality in the industry earnings. However, due to the environmental, social and governance (ESG) theme and political pressure, oil companies are not incentivized to put more rigs to extract more oil, but rather return most of the earnings to shareholders. Consequently, supply would not likely go up materially over the next few years. In terms of oil demand, global oil usage has exceeded the pre-pandemic level, but the supply is highly constrained.

Geopolitical turmoil

In recent years, there have been many geopolitical uncertainties such as conflict with China, the war in Ukraine, Middle East tensions, etc. Oil could be pressured on the upside as tension between rich oil-producing countries escalates.

Renewable energy is the future… but that future may be far!

Renewable energy is where the money is in the future, but that future could be many years or even decades from today. The global economy is just too dependent on oil. The ubiquity and cost of renewable alternatives are still not anywhere affordable for mainstream consumers and businesses. It is still a long time before large-scale renewable energy players change the landscape, making oil completely unnecessary.

Overall, these factors are potential catalysts that could likely drive favourable outcomes for long-term oil prices.

Oil Exchange-Traded Funds (ETFs)

We think it could make sense for Canadian investors to get exposure to the sector outlined above through low-cost, diversified ETFs. 

BMO Equal Weight Oil & Gas ETF (ZEO)

The BMO Equal Weight Oil & Gas ETF’s strategy is to replicate the performance of the Solactive Equal Weight Canada Oil & Gas index. ZEO has $197 million in assets under management (AUM), with a twelve-month trailing yield of 4.89%, and a Management Expense Ratio (MER) of 0.61%.

ZEO’s portfolio is broadly diversified with the top five holdings equally weighted, approximately 10.5% of the total portfolio each. The top five holdings consist of:

  • Pembina Pipeline Corporation, which provides energy transportation and midstream services through its pipelines and facilities. 
  • Keyera Corp engages in the processing, transportation, and storage of natural gas. 
  • TC Energy operates as an energy infrastructure company. 
  • Enbridge Inc., which provides a variety of related services for natural gas including transmission, distribution, storage, etc. 
  • ARC Resources Ltd., an explorer and producer of crude oil, and natural gas. 
  • Geographically, the ETF is mostly invested with complete exposure to the Canadian energy sector.

iShares S&P/TSX Capped Energy Index ETF (XEG)

The iShares S&P/TSX Capped Energy Index ETF is a well-established ETF with a decent AUM of around $1.7 billion and a MER of 0.60%. In terms of valuation, XEG has a P/E ratio of 6.0 times, and a twelve-month trailing yield of 4.35%, which is quite attractive. 

The ETFís portfolio currently has 31 holdings which is quite concentrated toward the top five companies. The top five largest positions account for almost 70% of the total portfolio, including Canadian Natural Resources (CNQ), one of the largest natural gas producers in Canada, Suncor Energy (SU), Cenovus Energy (CVE),  a Canadian oil company based mainly in northern Alberta and Saskatchewan, Tourmaline Oil Corp (TOU), a portfolio of assets in the Western Canadian Sedimentary Basin, and ARC Resources (ARX).

Horizons (NYMEX) Crude Oil ETF (HUC)

Finally, the Horizons NYMEX Crude Oil ETF, which is a direct play on oil prices. HUC is designed for investors who seek to own crude oil in a low-cost way. HUC provides investors exposure to the performance of the Solactive Light Sweet Crude Oil Winter MD Rolling Futures Index. 

HUC has a few unique features such as single-long exposure to the global benchmark price of oil. HUC has one contract roll per year which reduces the negative yield caused by a monthly roll. In addition, HUC provides currency hedged to the Canadian dollar, providing pure exposure to the commodity. The ETF has a small AUM of only $26 million and a MER of 0.98% which is slightly higher compared to the previous two ETFs.

 Michael Huyhn, Editor of the ETF Update, Analyst for 5i Research Inc.

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Disclosure: Authors, directors, partners and/or officers of 5i Research have a financial or other interest in XIT and ZRE.