Energy investors have a wide range of ETFs at their disposal, whether looking for broad energy exposure or certain subsectors. However, not all subsector ETFs are the same, especially when looking at those focused on oil and gas producers or exploration and production (E&P) companies.
Looking Under the Hood in E&P ETFs
The SPDR S&P Oil & Gas Exploration & Production ETF (XOP) and iShares U.S. Oil & Gas Exploration & Production ETF (IEO) are sizable E&P ETFs with important differences. XOP’s underlying index uses a modified equal weighting scheme, while IEO’s index uses a modified market cap weighting. XOP includes the integrated majors, Exxon (XOM) and Chevron (CVX), while IEO does not include them.
To be clear, E&Ps are companies that search for and produce oil and gas. Simply put, they extract oil, natural gas, or natural gas liquids from the earth and then make money by selling those commodities. Interestingly, despite their E&P focus, both XOP and IEO include the independent refiners – Valero (VLO), Marathon Petroleum (MPC), Phillips 66 (PSX), and their smaller peers. As of August 13, refiners represented 16.0% of XOP and 23.8% of IEO as shown below. Within IEO, MPC and PSX were the third and fourth-largest holdings at 9.2% and 7.6%, respectively.
Refiners Are Very Different From E&Ps
Refiners have different profitability drivers than E&Ps. Refiners process crude oil into gasoline, diesel, jet fuel, and other products like asphalt. Refiners make money on the difference between the price of their products and their cost of crude, less their operating expenses. E&Ps benefit when oil and gas prices are higher. Refiners tend to see more benefits when oil and gas prices are lower (natural gas is often used to fuel refineries).
One of the reasons to invest in an oil and gas E&P ETF is to get more exposure to oil and natural gas prices. However, the inclusion of refiners in these ETFs reduces their oil and gas price exposure and introduces different performance drivers. Given their sizable weightings, headwinds for the refining sector could be a drag on performance. Also, a key focus in the energy sector lately has been the long-term benefits for natural gas demand from power-hungry data centers related to artificial intelligence (read more). Refiners will not benefit from rising natural gas demand or higher natural gas prices.
A More Focused E&P Exposure
Investors looking for purer exposure to oil and gas producers may consider the Texas Capital Texas Oil Index ETF (OILT). The ETF’s underlying index screens for companies that produce oil and gas in Texas and constituents are weighted based on the economic value of their oil and gas production in the state with a 10% cap. By focusing on producers, the index does not include any independent refiners and provides purer E&P exposure than XOP and IEO. There are also benefits to focusing on producers in Texas (read more). OILT’s expense ratio of 0.35% matches XOP and is below IEO’s expense ratio of 0.40%.
The outlook for refiners is closely tied to demand for their products like gasoline and diesel, with diesel particularly sensitive to the outlook for the economy and industrial activity. When recession concerns resurfaced and market volatility increased earlier this month, refiners weakened. As shown below, seven out of eight refiners underperformed E&P ETFs month-to-date through August 13. Though downward pressure was broad-based, OILT was more resilient than XOP and IEO.
Bottom Line:
In certain market environments, refining exposure can be a fly in the ointment for E&P ETFs. For investors wanting purer exposure to companies that produce oil and natural gas, OILT may represent a better solution.
_Editor’s note: Stacey Morris, CFA, is Head of Energy Research at VettaFi. Before joining VettaFi to support the Alerian index suite, she led investor relations for an oil refiner and previously covered US refiners as a sell-side equity research associate. _
Related Research:
Bigger in Texas: Energy Reserves, Production & Exports
Looking for Exposure to Oil & Gas Producers? Try Texas
For more news, information, and analysis, visit the Energy Infrastructure Channel.
Vettafi.com is owned by VettaFi LLC (“VettaFi”). VettaFi is the index provider for OILT, for which it receives an index licensing fee. However, OILT is not issued, sponsored, endorsed, or sold by VettaFi, and VettaFi has no obligation or liability in connection with the issuance, administration, marketing, or trading of OILT.
