Oil Appreciation Day
Tuesday, December 6, 2016
November 30th certainly was oil appreciation day, with the always reliable OPEC members agreeing to cut production. The market certainly overlooked OPEC’s history of, shall we say, non-compliance with agreed production quotas, sending crude prices soaring. The only thing better than owning crude was owning energy companies, which outperformed even the 8% gain for oil.
One item we found particularly noteworthy were flows into energy-related ETFs, particularly XOP (SPDR S&P Oil & Gas Exploration & production ETF). Shares outstanding increased a meager 64% over two days, certainly driven by fundamental investors who coincidentally decided on 12/1 that they really wanted to own E&Ps.
|| Total Net Assets
The fund has only 58 holdings, many of which are small and mid cap companies with modest trading volumes. Accordingly, putting over $1 billion to work in a day can distort prices. While the fund was up almost 12%, its top ten holdings averaged a 21% gain, quite possibly because in a single day the fund traded, on average, 678% of the average daily volume for these top 10 names.
Here is what XOP looks like fundamentally, at least superficially. Digging deeper, we see 42 of the 58 holdings (72%) have no trailing earnings, so the 19.7X P/E is not accurate. The forward P/E of 42X is also not accurate as 35 holdings (60%) are not projected to make money even next year. The negative 56% ROE looks reasonable, though we calculated the average at negative 49%.
Much has been made of the effect of ETF flows on smaller cap stocks, though this example shows what can happen in very short order to a given sub-set of stocks, in this case within the energy sector. Steve DeSanctis of Jefferies provided this graph on overall ETF flows, which exclude these kind of sector-specific flows, but still show massive flows into small cap ETFs, which tend to favor illiquid, lower quality companies.
We would note his admonition that such flows could “reverse as quickly as they came in”, and our opinion would be that sector-specific ETF trades are even more prone to such reversals, given the macro-driven nature of many ETF traders, who are often headline driven.
With that as the backdrop, we think about what might cause such a reversal, and are reminded of a recent post we read on OPEC’s history of non-compliance: https://app.hedgeye.com/archives/55691-what-the-media-missed-opec-s-toothless-deal-to-cut-oil-production. We see from the following graph that production has historically exceeded quotas. Additionally, the whole deal is contingent on non-OPEC members agreeing to cuts, with Russia, supposedly on the hook for half of the non-OPEC reductions, already claiming they may have difficulty complying in the short-term due to technical issues.
Seems like the market’s reaction to the deal has been to assume OPEC has five aces and can move the price as they see fit. The short-term reaction of energy stocks, buoyed by outsized ETF flows, shows the market believes this, too, at least in the near-term. However, if anyone calls their bluff, these flows could just as easily turn, and we are not sure there are many incremental buyers for companies with such dreadful fundamentals.
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