Exercising Caution With Energy ETFs

The Energy Select Sector SPDR (NYSE:XLE), the largest exchange-traded fund tracking the energy sector, jumped more than 9 percent in September. That was easily the best monthly performance for the benchmark energy ETF this year and one that is sparking renewed enthusiasm for the energy sector, which is still the worst-performing group in the S&P 500 this year.

West Texas Intermediate futures reside around $50.50 per barrel, an improvement from recent pricing, but still a far cry from the $60 per barrel some energy market observers believe is necessary to truly make equity-based energy investments compelling. Getting to $60 per barrel could prove difficult, particularly if U.S. shale producers up production in advance of that highly anticipated price range being met or surpassed.

Lower global production costs, considerable U.S. shale growth potential and shale's ability to quickly respond to changing market conditions should keep average annual oil prices below $60 a barrel in the long term, said Fitch Ratings in a note out Monday.

What Really Moves Energy ETFs

Obviously, oil prices are an important of the price action equation for energy ETFs, such as XLE, but how crude prices affect a smaller number of big-name oil stocks truly charts the course for cap-weighted energy ETFs. For example, XLE devotes just over 40 percent of its combined weight to shares of Exxon Mobil Corporation (NYSE:XOM) and Chevron Corporation (NYSE:CVX), the two largest U.S. oil companies.

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While those integrated oil giants dominate XLE and other traditional energy ETFs, these funds also feature significant exposure to oil services providers and companies with major U.S. shale footprints.

The land rig count in the U.S. lower 48 has risen around 45 percent since the end of 2016, contributing to a rebound in U.S. crude production to over 9.5 million barrels a day (mmbbl/d) from a trough of about 8.4 mmbbl/d in July 2016, said Fitch. We continue to expect U.S. production growth to remain robust in the second half of 2017 based on the roughly two- to four-month lag between spudding shale wells and production.

Inventory Issues

There are still significant inventory issues that need to be whittled down before oil and the energy sector can convince investors a new bull market is starting.

Global inventories of both crude oil and refined products remain well above historical averages, said Fitch. However, Hurricane Harvey, which hit the U.S. Gulf Coast in early September, caused a steep decline in U.S. refinery utilization and widening of refiner margins. As U.S. Gulf Coast refiners re-establish operations, these wider margins should provide an economic incentive for refiners to meaningfully work through recent crude oil inventory builds.

Investors pulled $210.2 million from XLE in the third quarter.

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