XOP: Oil Could Get Unpredictable Come Summer

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The SPDR® S&P Oil & Gas Exploration & Production ETF (NYSEARCA:XOP) is a commodity sensitive instrument that tracks E&P players with assets focused on the U.S. It's a pretty efficient exchange-traded fund, or ETF, but we have some concerns and comments on the oil markets. There are gives and takes, but we think that if problems are going to start in oil markets, it will begin in the summer.

XOP Breakdown

XOP is pretty efficient, with 0.35% expense ratios against category averages around 0.52%. Holdings are what you'd expect. Around 70% of E&P, with direct commodity exposure to oil. 20% is in refinery stocks. This is a typical breakdown for U.S.-focused energy ETFs. Refinery isn't as directly commodity exposed. Part of the supply equation is also the supply of the refinery capacity itself, and part of the demand equation is for the refined products. Complexity also factors in since it offers optionality to maximize product margins, but U.S. refiners are mostly high complexity.

Another thing to add, independent of the commodity price situation, is the trend of consolidation among U.S. E&P players. Not long ago, shale oil used to be an unstable bet, since prices weren't that ahead of break evens. Now, of course, shale companies are printing money much like the rest of oil, and are driving down their drilled but uncompleted inventory to capitalize on these great prices at more than twice the U.S. share break evens. Consolidation is good for the industry in terms of its ability to get more efficient and deliver better cash flows. Also, credit profiles are improving, as the sponsor led transactions are getting financed with dry powder and industry leverage is under control. Also, if sponsors get even more active in this industry from troughs in activity that we've been seeing, with sponsor led M&A being the major shortfall in advisory, premiums could start kicking in as markets speculate on PE market exits. All good for the XOP.

Oil Comments

The situation in the oil markets is that prices are stalling with no new developments on supply or demand. Supply cuts had been the dominant force for the last year or so, and this has done a lot for prices as was necessary considering demand had begun to fall for refined products and therefore for crude as well. Run-cuts had started at refiners, and now the cuts are even more intense as crack spreads continue to hit pretty low levels and maintenance activities are being undertaken right now.

Part of the reason crack spreads are taking a hit are the relatively resilient crude prices on account of actions by OPEC members. The U.S. had deficits in reserves, and the OPEC countries shifted to a voluntary supply cut system as U.S. strategic demand kicked in. This may not last, and coordinated supply cuts could resume to keep putting pressure on the U.S. and the upcoming elections. Otherwise, there is upward pressure on prices on account of Iranian proxies continuing to make problems. For a while, we expect continued political incentives to keep the oil price where it is – at high levels. Our strong conviction is that major OPEC members are angling for a Biden loss in the upcoming elections, and looking to get concessions from Trump, who doesn't have constituents that care about things like the Saudi human rights record. Putting pressure on the American consumer wallet through high oil prices is a pretty good way to influence that outcome.

Another thing to consider on the supply side is that while drill baby drill will eventually lead to larger supply of oil from the large U.S. reserves, it takes time for capacity to actually get up and running. Increased production currently is all from low-hanging fruit of drilled but incomplete inventory at E&P companies. Those inventories are probably almost gone by now. The next wave of new capacity will take some years, even if a new administration like Trump's does a lot to support new asset development.

Where we think there may be the first speed bump is in the summer. In recent coverage of some advisory picks, we took to heart that usually in the summer before an election, you get a bit of an M&A and CAPEX freeze, and the coming U.S. election will have much more far-reaching geopolitical consequences. This could firstly impact oil demand negatively. It could also influence speculative activity in oil markets, as markets will likely assume that the possible Trump victory will create several avenues for a fall in the oil price. This would not be great for the XOP performance.

Bottom Line

And that's the bottom line. While it is by no means certain, we think downward pressure on the oil price, if it's ever to start, will be this summer. While a demand pick up would be an opposite pressure, we feel that oil demand would only really pick up once underlying inflation is more under control, which could happen sooner if oil prices fall, but probably not at the same time.

We'd be a little careful incrementing more money into oil at this point. If anything, maybe the refiners are the play now, if oil prices might fall and demand might be restored, leading up to and then solidified conditional on a Trump win.