It's Going To Be A Huge Day For Energy ETFs

The Energy Select Sector SPDR (ETF) XLE and rival equity-based energy exchange traded funds do not need any help spending time the limelight. Down 9.2 percent year-to-date, ranking it the worst of the nine sector SPDRs, XLE is getting plenty of negative of attention.

Depending on which way the earnings winds blow on Friday, it could be another trying day for XLE and comparable ETFs. Before the open of U.S. markets, Dow components Exxon Mobil Corporation XOM and Chevron Corporation CVX, the two largest U.S. oil companies, deliver second-quarter results.

Analysts expect Exxon to post second-quarter earnings of $1.11 a share, down from $1.66 a share a year-earlier. Chevron is expected deliver second-quarter earnings of $1.15 a share, down from $2.59 a share a year ago.

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Disappointments or sour forward guidance from either companies would deal a blow to struggling energy ETFs and the reason is obvious. Traditional sector ETFs, such as XLE and the Vanguard Energy ETF VDE, weight their components by market value. Translation: With Exxon and Chevron being the two largest U.S. oil companies by market cap, they command large, if not excessive positions in cap-weighted ETFs.

Breakdown

As of Wednesday, Exxon and Chevron combined for just over 29 percent of XLE's weight. Let's break that down to put the potential dangers into context. On that date, Exxon represented 16.5 percent of XLE while Chevron commanded 12.6 percent. None of the ETF's 40 other holdings have allocations in excess of 7.81 percent.

VDE, the Vanguard offering, exposes investors to even more Exxon/Chevron risk. At the end of the second quarter, those two stocks combined for 32.4 percent of VDE's weight. VDE's top 10 holdings commanded over 62 of the ETF's weight at the end of June, according to Vanguard data. Welcome to concentration risk.

Of course, the scenario outlined above cuts both ways. In a perfect bullish world, Exxon and Chevron surprise to the upside while delivering positive forward guidance, sparking in rallies in XLE and VDE. Chevron’s earnings update could be particularly important because the company has yet to announce a dividend increase this year, potentially jeopardizing a payout increase streak that spans 27 years.

Traders expecting the worst from Exxon and Chevron should get to know the ProShares UltraShort Oil & Gas DUG. DUG attempts to deliver twice the daily inverse performance of the Dow Jones U.S. Oil & Gas Index, the underlying benchmark for the iShares U.S. Energy ETF IYE, an ETF that devotes a combined 34.2 percent of its weight to Exxon and Chevron.