ETFs: How To Play The Energy Patch As Inflation Rises

Heading into 2018, scores of market observers speculated that inflation would move higher across major developed markets. Indeed, data confirm consumer prices are rising. In December, the Consumer Price Index rose 0.2 percent, according to the Bureau of Labor Statistics.

“The index for all items less food and energy increased 0.3 percent in December, its largest increase since January 2017,” said the BLS. “Along with the shelter index, the indexes for medical care, used cars and trucks, new vehicles and motor vehicle insurance were among those that increased in December.” 

Commodities, including energy commodities such as oil, are often thought to be strong inflation hedges. But there are decent and better ways for investors to view the energy patch in inflationary environments.

The Correlation To Watch

Equities are not historically highly correlated to inflation, but at the sector level, energy  is significantly more correlated to a rising CPI than other groups. That could bode well for exchange traded funds such as the Energy Select Sector SPDR XLE, assuming the CPI continues moving higher.

“Overall, equities are not that correlated with inflation at just over 0.2,” said S&P Dow Jones Indices. “However, the energy sector correlation to inflation of 0.6 is triple the correlation of the broad equities to inflation.  The crude oil futures are even more correlated to inflation, measuring over 0.8 — that is considered highly correlated. This is because energy is the most volatile component of CPI, essentially driving it.” 

XLE, the largest energy ETF by assets, holds 32 stocks with a weighted average market capitalization of $134.9 billion. Dow components Exxon Mobil Corp. XOM and Chevron Corp. CVX, the two largest U.S. oil companies, combine for almost 39 percent of the ETF's weight.

Small-Caps Too

As its weighted average market capitalization suggests, XLE is a large/mega-cap fund. Something to remember: small-cap energy stocks can perform well in inflationary environments because, in general, small-caps are more sensitive to inflation.

The S&P SmallCap 600 Index has an inflation beta of 3.1 compared to 2.6 for the S&P 500, according to S&P Dow Jones Indices.

That could open the door to inflation opportunity with the PowerShares S&P SmallCap Energy Portfolio PSCE, the small-cap rival to XLE. PSCE tracks the S&P SmallCap 600 Capped Energy Index, the energy offshoot of the S&P SmallCap 600.

PSCE holds 28 stocks with an average market cap of $1.57 billion.

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