IEO: U.S. Oil & Gas Is A Contrarian And Smart Investment

peshkov I am a big fan of stock picking. But I am also a big fan of sector-specific Exchange-Traded Funds. One such ETF I think is really interesting right now is the iShares U.S. Oil & Gas Exploration & Production ETF (BATS:IEO). This fund tracks the Dow Jones U.S. Select Oil Exploration & Production Index. It gives investors exposure to U.S. companies that are engaged in the exploration, production, and distribution of oil and gas. The fund holds 46 stocks of large and mid-sized companies. The fund is liquid, with a 30-Day Median Bid/Ask Spread of just 0.03%, and the fund trades very close to Net Asset Value. The sector is pretty cheap, with a trailing P/E ratio of 8.62x. An expense ratio of 0.40% is also at the lower end of the spectrum. What is good about the iShares suite of ETFs is there is a lot of useful information on the fund’s website to understand risk, fund composition, past performance and costs. I like the fund because it is focused on US names, which reduces international risk, and it is focused on mainly on crude oil, oil product and natural gas producers, in a medium term environment where I believe commodity prices will remain robust and production will grow. Investors who want some international exposure can consider the iShares MSCI Global Energy Producers ETF (FILL), however my preference in the ETF space is for a diversified basket of US companies as I think for international exposure more research needs to be done, and then it would be better to do hold a basket of individually selected stocks. The fund does not hold equipment and services names, whose companies are competing for market share in winning contracts and have to execute often complex projects at tight margins. Therefore, this ETF is a clean play on the macro view of strong oil, oil product and natural gas prices and production growth for US companies. Indeed, the whole oil & gas sector seems to be cheap right now, as the Energy sector (which is all oil and gas) currently makes just 3.6% of the weight of the S&P 500. With the importance of energy in the US and global economies, this seems far too low, even in an era where “data is the new oil”. Ironically, the data boom, is driving increasing energy demand as artificial intelligence boosts global data centre demand, data centres are highly electricity intensive. As data centres need to run 24/7, they cannot be supplied solely by renewable energy, and thus the gas fired electricity production is likely to grow faster in the next 10 years, as it has in the last ten years. The interesting thing about the IEO fund is it is actually quite diversified. iShares breaks it down into about 75% Oil & Gas Exploration & Production and 25% Oil & Gas Refining & Marketing & Transportation. The fund tracks the Dow Jones U.S. Select Oil Exploration & Production Index, which is a market cap weighted index, rebalanced quarterly. The fund picks the largest companies from the oil & gas exploration and production subsector in the US based on the Dow Jones Industry Classification System – DJICS – methodology. This market cap approach is a fair and sensible approach to broadly represent this subsector. In terms of weighting classification, my own analysis is slightly different. By my analysis I would say the fund currently holds about 65.5% of oil and gas exploration and production companies that are production heavy, given ConocoPhillips (COP) and EOG Resources (EOG) are the two largest holdings, making up a combined 29% of the fund’s weight. Both these companies are solid, and I will return to them later. These 25 E&P companies typically produce crude oil and condensate (light hydrocarbon liquid), natural gas liquids and natural gas. About 24% of the fund is in Refining and Marketing and oil product logistics, 10% in natural gas focused producers, including with natural gas liquids and liquified natural gas, 0.5% in ethanol producers, although large refining companies such as Marathon Petroleum (MPC), Phillips 66 (PSX) and Valero Energy (VLO) are not just gasoline producers but are building up capacity in biofuels such as ethanol and new fuels for sustainable aviation. So, the fund is not just a crude oil play, and the fund’s benchmark is slightly a misnomer. Let’s take a look at each component in a bit more detail. Crude Oil Different organisations have quite different forecasts for oil demand and supply. The International Energy Agency believes that demand will peak by the end of the decade and that there will be a glut of oil in the market. However, the IEA has been accused of bias in that it is making assumptions about the energy transition which may be too optimistic in the roll-out of clean energy. The Opec cartel is much more bullish about oil demand, although it can be accused of talking its own book. The US Energy Information Administration is somewhere in the middle, seeing oil demand growth past the end of this decade. While the rise of electric vehicles is a thread to oil demand, a recent Financial Times articles noted that the growth of EV sales in the US has been slowing, as EVs are still not competitive for the mass market and the US car fleet turnover is quite slow. My own view is that oil prices will hold steady has the wars in Ukraine and the Middle East disrupt oil international oil production and flows and embed a higher than normal risk premium in the oil price. Ukraine, in recent months, has been attacking Russian oil refineries with drones and this certainly is an upside risk for oil prices if this continues. Because of this, US producers are incentivised to grow production, and that is what has been happening. In early June, Opec+ members agreed to extend deep cuts in oil production, in some cases to the end of 2025, as they battle to shore up prices amid weak global demand and increased supply from other parts of the world. The book Oil Leaders by Ibrahim Al Muhanna who is an adviser to the energy minister of Saudi Arabia, notes how over the medium term, OPEC has been successful in managing the price to a level members want and need. According to Reuters, OPEC currently favours a price closer to $90 a barrel. So my view is the medium term oil price will average around $90/bbl. The fund holds Hess Corp (HES) and Marathon Oil Corp (MRO), which are being acquired by Chevron and ConocoPhillips respectively. Natural Gas Not only do we have the electrification of cars (albeit slowing) and the growth of energy-intensive data centres, but in April this year the G7 agreed to end use of unabated coal power plants by 2035. According to Energy Intelligence, coal accounts for roughly 37% of the world’s electricity production and 15% of G7 countries’ production. Energy Intelligence notes, “Phasing out coal likely means G7 countries will rely more on natural gas while they continue to build out the capacity of renewables and the technology of nuclear energy.” All this makes me very bullish on natural gas, and I believe over time, the IEO fund will become less oily and more gassy. The important thing is that the fund already has good exposure to natural gas, holding for example EQT Corp (EQT), and Chesapeake Energy (CHK) and Southwestern Energy (SWN) which are in the process of merging. The fund also holds Kosmos Energy and Tellurian, which both have important LNG assets. With the ongoing ware in war in Ukraine, and Europe unable to rely on Russian gas imports, international LNG is becoming an important market to plug those shortfalls. Refining & Marketing As mentioned, this fund has quite a heavy weight towards refining and marketing companies and holds nine companies in this subsector. The three largest, Marathon Petroleum Corp (MPC), Phillips 66 (PSX) and Valero Energy (VLO), in total make up 21% of the fund. PSX not long ago announced it is getting rid of non-core assets and VLO has said it is going to pay out 100% of free cash flow to shareholders. All three companies are growing their biofuels business as a long-term hedge against the energy transition. The ETF also holds two small ethanol pure plays, Green Plains Inc. (GPRE) and Rex American Resources Corp (REX). Concentrated positions The fund’s two largest positions are ConocoPhillips (COP) and EOG Resources (EOG) are the two largest holdings, at about 19% and 10% of the fund’s weight respectively. This might grow as ConocoPhillips acquires fellow holding Marathon Oil. SA Analysts give COP a 4.00 / BUY rating. The most recent analyst to cover COP has a Strong Buy rating, and writes how the Marathon Oil deal will create potential for synergy effects and dividend growth and notes “the company is set for accelerating capital returns”. For me, one thing I like about COP is that on its board, its Audit and Finance Committee Chair is Arjun N. Murti, who was one of the best energy analysts on Wall Street at Goldman Sachs in the first part of this century. This really bodes well for capital allocation at COP. EOG Resources (EOG) is the second-largest holding. SA Analysts also give EOG a 4.00 / BUY rating. The most recent article on EOG calls the company “a top-tier liquid-weighted shale producer with strong financial projections and stock price improvement potential.” And also “EOG Resources is committed to cost control, technology innovation, and capital return to shareholders, making it a strong investment option in the current market conditions.” Indeed, EOG has been a leader in technology innovation. The company pioneered the Enhanced Oil Recovery – EOR – method of oil production from shale rock back in 2016. In the Q3 2023 earnings call, management said, “We’re still seeing the outstanding strong results that we talked about earlier. Consistently 20% uplift in the first-year production in EOR.” The third-largest position of the fund with about 8.9% weight is Marathon Petroleum (MPC). SA Analysts also give MPC a 4.00 / BUY rating. The most recent article about the company notes MPC remains bullish on the future of refined products and margins, with a strong midstream segment and commitment to shareholder value through buybacks and dividends. Risks Clearly, energy commodity prices and production levels are a risk, and investors might want to regularly read the monthly reports from the International Energy Agency – IEA -, the Energy Information Administration – EIA -, and OPEC to keep an eye on market conditions, as well as follow regulatory filings from and Seeking Alpha articles on COP and EOG to follow developments at these two large holdings in the fund. Having nearly 20% in one holding does present a somewhat idiosyncratic risk, although I am confident in the management of ConocoPhillips, but the risk is less than holding any one company due to the diversified nature of the overall fund. Because my view is for production growth across the sector, which is what both the IEA and EIA are predicting, and for robust or increasing energy commodity prices, then over the medium term I believe earnings will grow steadily. This means even if the fund’s P/E of 8.6x doesn’t rerate, the fund’s net asset value will still increase. However, as investors realise the importance of the energy sector, given the demand growth and increased need for energy security, there should be improved sentiment around the sector leading to P/E multiple expansion. So I believe the net asset value of the fund should increase with growing earnings, driven by revenue that grows through both price and volume appreciation, and multiple expansion. Given the trading liquidity of the fund, the fund price should track closely to the Net Asset Value, as it is now. Conclusion The iShares U.S. Oil & Gas Exploration & Production ETF gives broad exposure to an important sector, which I feel is broadly underweight in the US stock market. Although the top five holdings make up about 50% of the fund, these are robust companies. Excluding the integrated oil and gas companies, every company in the fund is a pure play company as an Exploration and Production company or Refining and Marketing company, with decent exposure to the long-term growth areas of natural gas production, LNG trade, and biofuels demand, while the medium-term outlook for oil production is also robust. The U.S. nature of the companies reduces the geopolitical risks for the fund at the holding level Final note: there are alternative oil and gas ETFs to consider, which are each have different themes and subsector exposures than IEO has, but my preference at the moment is IEO given the above analysis: iShares U.S. Oil Equipment & Services ETF (IEZ) SPDR® S&P Oil & Gas Equipment & Services ETF (XES) iShares MSCI Global Energy Producers ETF (FILL) VanEck Oil Refiners ETF (CRAK)

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