Oil prices have been on a wild ride the last few years to say the least. There are many ways to play these trends. You can buy crude oil futures [s: CLN12.NYM] and hedge with airline stocks, though not always a good oil hedge. The point is that there are many options, but few maximize risk/reward better than the trade I propose.
One of the safest and best ways to maximize profits in the oil sector is to use an ETF pair trade (i.e. long/short) strategy focused on maximizing upside potential and minimizing downside risk.
One often-overlooked advantage to ETFs is that we know their holdings and allocations every day. Mutual funds often take weeks or months to disclose their holdings. Many articles have been written about how that lack of transparency allows mutual fund managers to window-dress their holdings. That is not possible with ETFs.
My bottoms-up analysis of ETFs based on their holdings drives my predictive ratings (defined here) on ETFs. These ratings allow investors to know more about the relative merits of ETFs.
As I have shown in my Best & Worst ETFs articles, you cannot trust ETF labels. We cover 21 Energy ETFs and they hold anywhere from 24 to 147 stocks. That wide range means the performance of the ETFs is likely to be very different. My free ETF screener provides my ratings and reports on all 21 Energy ETFs.
Further, some Energy ETFs hold good stocks and others do not. Per my Best & Worst ETFs & Mutual Funds: Energy Sector report, investors need to tread carefully when considering Energy ETFs. Only one out of twenty-one get an Attractive rating and is worth buying because it allocates enough value to Attractive-or-better-rated stocks.
Part of the reason so few Energy ETFs get an Attractive-or-better rating is that there are not that many good Energy stocks to choose from. 58% of the 194 Energy stocks I cover are rated Dangerous or worse. 87% are rated Neutral or worse. My stock ratings are defined here.
The ETF pair trade I propose maximizes the value of my research by identifying the very best ETF(s) to be long: PowerShares Dynamic Energy E&P [s: PXE], and the very worst ETF to be short, Direxion Daily Natural Gas Related Bull 3x Shares [s: GASL]. PXE is my top-rated Energy ETF and the only Attractive-rated Energy ETF. GASL is my worst-rated ETF and the only Very Dangerous-rated Energy ETF. Both are relatively small and less liquid than some investors like so I propose a more liquid pair below.
If you need a more liquid alternative for this pair trade, I recommend going long Vanguard Energy ETF [s: VDE] and shorting First Trust ISE-Revere Natural Gas Index Fund [s: FCG]. VDE is my #2-top-rated Energy ETF and gets my Neutral rating. FCG is my #2-worst-rated ETF and gets my Dangerous rating. Both of these ETFs are highly liquid.
PXE gets my Attractive rating because it allocates over 50% of its value to Attractive-or-better rated stocks. Only 12.5% of the portfolio is in Dangerous-rated stocks and nothing is in Very Dangerous-rated stocks. PXE has a higher expense ratio of 0.60% than VDE at 0.19%, but it gets a better rating because it holds significantly better stocks than VDE.
On the short side, GASL charges a 0.95% expense ratio and holds no Attractive-or-better-rated stocks. 36% of its portfolio is in Neutral-rated stocks, 45% is in Dangerous stocks and 4% in Very Dangerous-rated stocks. Worse yet, the ETF is levered 3x, which means it could be extremely volatile. In other words, GASL is a perfect example of a Very Dangerous ETF: high costs, holds bad stocks and lots of leverage, a combination that could fire-bomb your portfolio.
FCG is not as bad as GASL only because its expense ratio is lower at 0.60% and it is not levered. Otherwise, its portfolio allocations are nearly identical to GASL: 0% in Attractive-or-better-rated stocks, 36% in Neutral-rated stocks, 45% is in Dangerous stocks and 4% in Very Dangerous-rated stocks.
Going long PXE or VDE gives investors exposure to the best that Energy ETFs offer. Shorting the worst that Energy ETFs have to offer, i.e. GASL or FCG, minimizes risk of loss. Win win.
Two of my favorite stocks held by both PXE and VDE are Exxon Mobil [s: XOM] and ConocoPhillips [s: COP]. Both stocks get my Very Attractive rating because of their positive and rising economic earnings and cheap valuations. Both stocks offer excellent risk/reward because of their excellent cash flows and the low expectations in their stocks prices. At $52/share, the expectations in XOM’s stock price imply the company’s after-tax cash flow (NOPAT) will permanently decline by over 40%. For COP at $51.30/share, the stock price implies the company’s NOPAT will permanently decline by nearly 70%. With valuations so low, investors have little to lose and lots to gain in these stocks.
One of my least favorite stocks held by both GASL and FCG is Cabot Oil & Gas [s: COG). This stock is also on my Most Dangerous Stocks list for June. It makes that list because (1) the company reports positive and rising GAAP earnings while economic earnings are negative and declining and (2) the valuation is sky high. COG’s GAAP earnings move in the opposite direction of their economic earnings because $17 million in off-balance sheet debt and $313 million in accumulate asset write-downs. The $313 million in asset-write-downs is a indicator of management’s inability to create shareholder value. It means that for every dollar of capital in the business management is destroying about 10 cents. Despite what the accounting results show, this company is not making money.
However, the stock market’s valuation of the stock completely overlooks this point. At $31.13/share, the valuation of COG stock implies the company will grow is NOPAT at nearly 25% compounded annually for ten years. Those are some lofty expectations. Too high and too much risk for me especially when my model shows the company is not growing its NOPAT at all.
Disclosure: I am long XOM and COP. I receive no compensation to write about any specific stock, sector or theme.
