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Opus News & Insights

Oil Appreciation Day
Tuesday, December 6, 2016

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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.

Date   NAV    Share Outstanding  Total Net Assets 
01-Dec-2016    42.05    68,350,000  2,873,916,625 
30-Nov-2016    41.88    43,100,000  1,804,976,660 
29-Nov-2016    37.60    41,750,000 1,569,855,460 


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%.

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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.

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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.

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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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