How Energy Sector companies work together to supply oil and gas
The economy is powered by the Energy Sector. The companies in the Energy Sector are involved in exploring, extracting, processing, and delivering energy resources to meet the needs of the enterprises. There are many kinds of energy the sector supplies. The network of companies in the Energy Sector is complex as the functions of all sector participants vary. Take oil and gas, for example. Some companies explore and develop the reserves; others focus on drilling and refining. The companies are mostly categorized by how the energy they are involved in is sourced.
Energy companies are divided into two big groups: Non-renewable (such as oil, natural gas, heating oil, etc.) and renewable (hydropower, wind or solar power, etc.)
The most prominent companies in the sector are involved in oil and gas.
They fall into two big categories:
- Extraction of Oil and Gas – These companies extract the resource by drilling, pumping, and producing oil and natural gas.
- Delivery and Refining – After oil and gas are extracted, it must be transported to a refinery where the final product is made of it, such as gasoline.
The revenues of the companies involved in oil and gas are dependent on the world market prices of these commodities. When oil and gas prices fall to critical levels, many companies can go out of business. For example, Chesapeake Energy Corp. is preparing for a potential bankruptcy filing as WTI broke down the $40 per barrel level in March 2020 and bottomed at negative prices in April.
Understanding the investing in the Energy Sector ETF
What are the risks?
Before investing in Oil and Gas, we must consider the possible risks pertaining to this industry. The risks include world price change risk, dividend cuts, oil spill risk (such as the one on April 10, 2010, known as “BP Oil spill” or “Gulf of Mexico oil spill”).
Gauging the price is the game of supply and demand
The change in the price of oil is caused by changes in the world’s supply and demand, which is primarily affected by OPEC cartel. An investor can estimate the balance of the demand versus supply following International Energy Agency reports. As the rule of thumb, rising oil prices decrease the demand, which is mainly the case for developed countries like the US or Eurozone. At the same time, it’s harder to project the reaction of the emerging markets to the oil price change. As there is still rapid growth potential in Asia (talking about 5-10% yearly GDP growth), over the long-term, there should be room for oil demand coming from this region. As for the supply, an investor should track the production capacities and policies of the leading oil and gas producers: The United States, Russia, and Saudi Arabia. By summing up their capacities, we can roughly estimate medium to long-term tendencies of oil and gas prices. There are two primary grades of oil – West Texas Intermediate (WTI) and Brent. Brent is typically more expensive than WTI due to its quality. Arguably, Brent oil is a better global indicator of oil prices.
Get exposed to the sector
It’s quite problematic to invest in physical oil for the majority of investors. Instead, a convenient way is to use various liquid markets that enable exposure to oil and gas. The liquid markets are derivatives and stocks. Among derivatives, the most popular are oil futures and options. In the stock market, you can invest in ETFs or individual oil company stocks.
The Major Energy sector ETFs
One of the best vehicles to get exposure to a particular sector is the ETF. Investing in ETF can help the investor to get more objective exposure to the sector while cutting the expense costs.
Here is the table of the top three energy sector ETFs by their assets under management:
Assets under management
Energy Select Sector SPDR Fund (NYSE: XLE)
Alerian MLP ETF (NYSE: AMLP)
Vanguard Energy ETF (NYSE: VDE)
Here are the top three holdings of XLE, VDE, and AMLP:
- XLE: Chevron Corp – 23.52%, Exxon Mobil Corp – 23.03%, Kinder Morgan Inc – 4.60%.
- VDE: Exxon Mobil Corp – 22.60%, Chevron Corp – 21.16%, ConocoPhillips – 4.32%
- AMLP: MPLX LP – 10.82%, Enterprise Products Partners LP – 10.66%, Magellan Midstream Partners LP – 10.51%.
XLE can have some concentration issues and might not be the best choice for buy and hold strategy. As we see, the top three stocks take over 50% of the ETF’s portfolio. XLE and VDE focus their holdings on exploration, production, and processing of oil and gas.
Although the portfolio of VDE is similarly taken over by the top three holdings, overall, VDE has more individual stocks in the portfolio, making it more diversified.
AMLP focuses on a different group of oil and gas companies. The ETF offers exposure to the oil and gas transportation and storage. As the fund seeks to get exposure to the assets that are not directly impacted by commodity prices, AMLP is not taxed as a corporation but as a partnership.
How to trade and how to invest in Energy ETF
Stay with the winners
Investing in the energy sector is essentially betting on the performance of the sector’s underlying commodities – primarily oil and gas. With this year’s crash in oil prices, most likely any investor going long at the beginning of 2020 would experience a drawdown. However, those that focused on the small-caps would suffer more. Why? Smaller companies have far fewer financial resources to withstand reduced incomes and more potentially defaultable corporate bonds. Look at the comparison of the performers in 2020 from Oil & Gas Exploration and Production. Here are the top losers from small-caps and large-caps:
The average YTD loss of small-caps is -73.02%, while the large-caps’ is -46.19%. That means different companies react to the prices changes differently. This “noise” can diminish investor’s returns significantly. Trading with ETFs can protect the investor from such “noise” through the effect of diversification.
Look for the relative strength
Below are the charts of XLE and Brent. We know, that XLE is dependent on oil prices, so it should usually follow Brent making the similar swings. Both instruments make a New Low (NL). Afterward, Brent makes a Lower Low (LL1), but at the same time, XLE makes a Higher Low (HL1). Similarly, XLE keeps moving higher, producing a higher low intraday (HL2) while Brent is creating a new Lower Low (LL2). It implies that XLE has a relative strength versus Brent. We have a buy signal after we can identify two swings. The third swing (HL2 or LL2) can serve as a confirmation signal.
The energy sector is diverse and includes the companies that explore, extract, produce, transport, and store the oil and gas. The incomes of the sector are dependent on world commodity prices as the margins contract when the prices decline. An investor must be aware of the risks that pertain to the industry, particularly oil spills and commodities price volatility. The world supply and demand determine commodity prices. Tracking the demand and output data from International Agency reports can help the investor to estimate the chances of the commodity price to go either direction. There are numerous ways to invest in the Energy sector; ETF is one of the most convenient ones. ETFs can help the investor to mitigate the risks associated with individual companies, especially small-caps. As the biggest ETFs (by AUM) are often quite concentrated, investors should pay attention to the portfolio structures of the funds to ensure proper diversification.