Trader Talk

Trying to pick a bottom in energy stocks

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Trying to pick a bottom in energy stocks: is this the time to go long?

A lot of traders seem to think so. It's a huge day for energy stocks, with many up double digits. Not surprisingly, ETFs associated with energy and commodities are seeing heavy volume.

Since this is the first notable up day since energy stocks started falling out of bed a little over two months ago, this is a good time to review how an investor might play a bounce in energy.

Fortunately, the ETF world has an ample supply of investment opportunities in energy.

Time to buy into energy meltdown?

There are three big cap choices, all similar offerings from the Big Three of the ETF world: Energy Select (XLE) from SPDR (State Street), Vanguard Energy Index (VDE) from Vanguard, and iShares U.S. Energy Index (IYE) from BlackRock.

These are all fine choices, but they all suffer from a similar problem: because they are market-cap weighted, they all have very heavy exposure to the same names: Exxon, Chevron, Schlumberger, Conoco, Occidental, etc.

The XLE tracks the Energy Select Sector Index and represents all the big-cap names in the S&P 500, ignoring small and mid-cap names. The VDE and the IYE track different indices, but the effect is the same: a heavy weighting to the biggest names.

The XLE, for example, has 61 percent of the fund in just the top 10 names. Same with VDE; essentially the same with the IYE. See what I mean?

There's nothing wrong with this approach. Energy is far-and-away the worst performing sector in the S&P 500 this year, down almost 16 percent. It would make perfect sense to essentially buy the entire energy sector in one fell swoop, and then just sit on it.

However, given the similarities, cost is a consideration. The big advantage of the VDE and XLE is low cost: 14 basis points for the VDE, 16 basis points for the XLE, and 46 basis points for the IYE. That's a big difference, considering the performance of all three are very similar.

To get more beta, you have to look at smaller slices of the energy business. The most obvious choice is the SPDR Exploration & Production ETF (XOP).

Unlike the above ETFs, this tracks an index that is equal-weighted. That's a big difference: the top 10 holdings are only about 17 percent of the total weight.

This obviously includes the big E&P names, but it also includes refiners like Tesoro (TSO) and Valero (VLO), as well as smaller refiners like PBF Energy (PBF) all of which have held up a bit better than diversified oil companies.

The biggest issue is that it is a bit expensive, at 35 basis points, but given the sector and the unusual equal-weighted nature of the ETF, it may well be worth it.

The Market Vectors Oil Service ETF (OIH) is another choice, but it has a problem: a very heavy concentration in the top names. Schlumberger (SLB), for example, is about 23 percent of the holdings; Halliburton (HAL) 10 percent, National Oilwell Varco (NOV) almost 9 percent, Baker Hughes (BHI) almost 6 percent. The top 5 holdings are almost 50 percent of the weighting in the index.

If you want to play the big global names, there is the iShares Global Energy ETF (IXC), which owns all the big names roughly by market cap: Exxon (XOM), Chevron (CVX), Total, Royal Dutch, BP, Schlumberger, Conoco Phillips, but again we have a problem with concentration. The top 10 holdings are roughly 50 percent of the value of the index.

There are more, but once you get a little farther down the food chain the liquidity gets thin. My advice is stay with the established ETFs.

So what to buy? Is this the right time? I have no doubt there could be more pressure in the short-term as year-end positioning continues (this I keep hearing from traders) loss selling and portfolio clean-up likely to come in the next week.

That's why a lot of people think you are sticking your hand in a briar patch trying to buy these stocks now.

They may be right, but I'm not so sure. The one thing I have seen in my 17 years as the Stocks Editor is that the worst performing sector one year often turns around in the following year as Value investors step in.

Everyone assumes you can't do anything until you see a clear bottom in crude, but I'm not so sure about that either. Let me put it this way: is it more likely we are going to see oil in the $40s six months from now, or in the $50s or $60s? My bet is the latter: with oil down more than 40 percent, the risk is to the upside in the long run as production declines.

Assuming oil stabilizes somewhere around the mid-$50s to mid-$60s, there's no doubt equity prices will rise. These stocks are WAY oversold, even if a few do not survive. That's why you buy ETFs!