Being Patient With E&P ETFs

Energy stocks and exchange-traded funds are rebounding off their previous lows, but the sector remains the worst-performing group in the S&P 500 this year. Problems for the broader energy sector include lagging exploration and production stocks.

The SPDR S&P Oil & Gas Exploration & Production ETF XOP, the largest ETF dedicated to exploration and production stocks, is down 17.2 percent year to date, a loss that is more than twice as bad as basic, diversified energy ETFs. The PowerShares Dynamic Energy Exploration & Production Portfolio PXE has been less bad with a year-to-date loss of 9.1 percent.

PXE's methodology is clearly proving superior to competing exploration and production ETFs, but there are myriad issues facing the exploration and production group, requiting ambitious investors be patient with related stocks and ETFs.

Mediocre Math

Some market observers believe some of the math pertaining to exploration and production is less than compelling.

“Energy companies have generally not offered a high level of cash flow return on their invested capital (CFROI),” according to Invesco research. “The average E&P stock has delivered an annual CFROI of about 3 percent on average since 1955. That pales in comparison to the average stock in the S&P 500, which has delivered a 9% CFROI on average over the same period.”

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To that point, PXE could be a better bet among exploration and production because the fund seeks out stocks with quality, steady management and earnings momentum. Since inception, PXE's underlying index is up 3.5 percent compared to a gain of 0.8 percent for the S&P Oil & Gas Exploration & Production Index.

Looking For Value

With the exploration and production space still scuffling, there could be some value opportunities for prescient investors.

“Within this long-term trend, there have been times when — at the bottom of an energy cycle — value investors could identify a few E&P stocks that were selling at deep discounts to their reserve values, and could make money for a few years in spite of the industry’s lack of capital discipline,” said Invesco. “That is, until this cycle. Today, E&P companies have reached a new level of capital irresponsibility, and most are actually generating negative returns and losing money for their shareholders — making that historical 3 percent return actually look good in comparison.”

PXE allocates a combined 15 percent of its weight to Devon Energy Corp DVN, ConocoPhillips COP and Anadarko Petroleum Corporation APC.