Higher Interest Rates Could Benefit Energy ETFs

The Energy Select Sector SPDR (NYSEArca: XLE), the largest equity-based energy exchange traded fund, is one of the best performers among the sector SPDR suite of ETFs this year. Obviously, rebounding oil prices are playing a significant role in XLE’s 2016 resurgence, but higher interest rates, if that scenario finally comes to pass, could boost energy ETFs as well.

Some oil related assets, including master limited partnerships (MLPs), are benefiting from lower interest rates. However, traditional oil equities are seen as cyclical plays. That means the energy sector could get a lift from higher interest rates because such a move by the Federal Reserve would signal confidence in the U.S. economy.

MLPs primarily deal with the distribution and storage of energy products, so their business model is less reliant on the commodities market since MLPs profit off the quantity of oil and natural gas they are able to move around.

“As a result, low cost of capital makes new non-fossil facilities more competitive with new fossil-fueled plant. The current low interest rate environment favors non-fossil power generation. Carbon emissions reductions that result can also be seen as an unexpected conse-quence of low interest rates,” according to OilPrice.com.

Rivals to XLE include the Vanguard Energy ETF (NYSEArca: VDE), iShares U.S. Energy ETF (NYSEArca: IYE) and the Fidelity MSCI Energy Index ETF (NYSEArca: FENY).

The energy sector is just one of two S&P 500 sectors that currently trades at a noticeable discount to its long-term averages. Additionally, the energy sector is usually among one of the largest sector weights in value ETFs, underscoring the point that the group is attractively valued relative to some defensive sectors, which trade at lofty multiples.

Plenty of skeptics remain regarding oil’s fundamental outlook. There might be something to that skepticism as many of the world’s major ex-U.S. producers of oil have not displayed a willingness to pare production. Even the output reductions in the U.S. have been modest. The good news is U.S. shale output is slightly declining, but challenges remain on the output front from OPEC producers.

“Low natural rates of interest favor renewables, nuclear power and other capital intensive businesses that benefit disproportionately from low cost money. Legacy investments made in a higher interest rate envi-ronment for the moment still offer relatively high potential returns to equity capital. The future rate is probably lower,” notes OilPrice.com.

For more information on Energy ETFs, visit our Energy category.

Energy Select Sector SPDR

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.

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