A Rewarding Oil Trade With An iShares ETF

The energy sector is shedding its laggard status in a big way. Last month, energy was the best-performing sector in the S&P 500 by a substantial margin. Even traditional energy exchange traded funds, which are typically heavy on a small amount of integrated oil stocks, delivered double-digit April returns.

Some ETFs dedicated to energy sub-industry groups, such exploration and production and oil services, are delivering stellar second-quarter returns. That includes the iShares U.S. Oil Equipment & Services ETF (NYSE:IEZ).

What Happened

Since the start of the second quarter, IEZ is up more than 18 percent, outpacing traditional energy ETFs as well as the United States Oil Fund (NYSE:USO). The $235.33-million IEZ tracks the Dow Jones U.S. Select Oil Equipment & Services Index and holds 35 stocks.

For investors seeking exposure to oil today, we see a stronger case for investing in energy equities over crude itself or energy-related debt, BlackRock said in a recent note. Oil prices have run well ahead of energy stocks this year, but this trend has started to turn. One factor supporting energy firms: their focus on capital discipline, evident in first-quarter earnings results. Unlike in some past oil market rallies, companies are not making huge investments in future production. Instead, they are using free cash flow to return capital to shareholders via increased buybacks and dividends.

Why It's Important

As IEZ's second-quarter performance shows, oil services stocks can be highly responsive to oil price movements. Historically, oil services equities have displayed intimate correlations to oil prices in both directions, meaning IEZ and rival ETFs could be vulnerable if oil prices suddenly reverse to the downside.

IEZ is also a top-heavy fund. Just two stocks Schlumberger NV (NYSE:SLB) and Halliburton Inc. (NYSE:HAL) combine for almost 26 percent of the fund's weight. Underscoring the correlation to oil prices, IEZ has a three-year standard deviation of 30 percent, indicating this ETF is far more volatile than standard diversified energy funds.

What's Next

While IEZ has rallied considerably in recent weeks, some data points suggest the energy sector has more upside potential.

Current oil prices offer potential upside for energy companies earnings and stock prices, BlackRock said. Most energy companies have budgeted for mid-$50s oil prices in 2018, with this conservative outlook reflected in share prices today. This points to valuation upside should current levels of oil prices be sustained.

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