Expectations of an improving economy and bullish supply data have strengthened oil prices to around $95 per barrel. Crude’s recent run has been spurred by the Federal Reserve’s measured Taper announcement, based on assertion that the U.S. economy was strong enough.
This has fueled hopes for robust fuel and energy demand in the world’s biggest oil consumer. The bullish momentum was further propelled by positive revision to third quarter GDP numbers and continued decline in U.S. supplies.
Partly offsetting this favorable view has been a spike in domestic production — now at their highest levels since 1988 – and suggestions of increase in Libyan oil exports following months of political turmoil.
The immediate outlook for oil, however, remains positive given the commodity’s constrained supply picture. In particular, while the Western economies exhibit sluggish growth prospects, global oil consumption is expected to get a boost from sustained strength in China, the Middle East, Central and South America that continue to expand at a healthy rate. (Read: 3 Commodity ETFs still looking strong)
According to the Energy Information Administration (EIA), which provides official energy statistics from the U.S. Government, world crude consumption grew by an estimated 1.1 million barrels per day in 2013 to a record-high level of 90.3 million barrels per day.
The agency, in its most recent Short-Term Energy Outlook, said that it expects global oil demand growth by another 1.2 million barrels per day in 2014. Importantly, EIA’s latest report assumes that world supply is also likely to go up by 1.2 million barrels per day in 2014.
In our view, crude prices in the first half of 2014 are likely to exhibit a sideways-to-bearish trend, 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.
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. (Read: Volatility ETFs crash as market fears drop)
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).
Investors continue to focus on temperature patterns to understand the fuel’s economic dynamics. As it is, natural gas fundamentals look uninspiring with supplies remaining ample in the face of underwhelming demand. In fact, it is expected to take many years for the commodity’s demand to match supply in the face of newer projects.
Despite these issues, natural gas rallied to a two-year high recently on the back of persistent decreases in supplies and freezing cold weather conditions, which boost natural gas demand for space heating by residential/commercial consumers.
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 (NYSEARCA: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 79 stocks of companies that finds and produces oil and gas, with the top holdings being Magnum Hunter Resources Corp. (MHR), Green Plains Renewable Energy Inc.(GPRE) and Valero Energy Corp. (VLO). The fund’s expense ratio is 0.35% and pays out a dividend yield of 0.86%. XOP has about $617.7 million in assets under management as of Jan 14, 2014.
iShares Dow Jones US Oil & Gas Exploration & Production ETF (NYSEARCA:IEO):
This fund began in May 1, 2006 and is based on a free-float adjusted market capitalization-weighted index of 75 stocks focused on exploration and production. The top three holdings are ConocoPhillips (COP), Phillips 66 (PSX) and EOG Resources Inc. (EOG). It charges 0.45% in expense ratio, while the yield is 0.90% as of now. IEO has managed to attract $421.5 million in assets under management till Jan 14, 2014.
PowerShares Dynamic Energy Exploration and Production (NYSEARCA: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 Valero Energy Corp, Marathon Petroleum Corp. (MPC) and EOG Resources Inc. The fund’s expense ratio is 0.65% and the dividend yield is 1.75%, while it has got $109.7 million in assets under management as of Jan 14, 2014.
This article is brought to you courtesy of Eric Dutram.