IEZ - Crude Calculations: Assessing IEZ's Pros And Cons

2023-08-18 17:14:22 ET

Summary

• IEZ offers exposure to leading oilfield services companies who can benefit from the strength in international and offshore markets.
• IEZ has a pronounced allocation to large-cap companies like SLB and Baker Hughes, which make up 40% of the ETF's total assets.
• OIH may be a superior option to IEZ due to its portfolio structure, size, liquidity, and lower expense ratio.

Introduction

You know how sometimes you find a book, and at first glance, it seems like the perfect read? But as other books on the same shelf catch your eye, the first choice does not look so straightforward anymore. That's kind of how I felt about the iShares U.S. Oil Equipment & Services ETF ( IEZ ). At a glance, it looked great, fitting perfectly with my investment thesis.

For those who've kept up with my musings, you might remember my deep dives into a couple of oilfield services ETFs - specifically, the VanEck Oil Services ETF ( OIH ) and the Invesco Dynamic Oil & Gas Services ETF ( PXJ ). Venturing further into this realm, I've dissected IEZ. While it initially presented as a stellar contender, pitting it against its counterparts gave me pause. Let's delve into why this might not be the clear winner for investors after all.

About IEZ

The iShares U.S. Oil Equipment & Services ETF, or IEZ, offers investors a pathway into the realm of companies specializing in equipment and services for oil and gas exploration and production. This ETF holds 29 U.S.-listed entities in the oilfield equipment and services domain. This spectrum spans from industry giants like SLB ( SLB ) (previously known as Schlumberger) - the global frontrunner in the sector - to more niche, small-cap firms like U.S. Silica Holdings ( SLCA ), a supplier of frac sand to shale drillers.

Interestingly, IEZ exhibits a pronounced preference for its large-cap constituents. A notable emphasis is laid on SLB and Baker Hughes ( BKR ), with these two companies alone shouldering over 40% of the ETF's total assets. In fact, the top-10 companies within IEZ cumulatively constitute more than 70% of its asset base, all of which are mid-to-large-cap stocks, extending from SLB to TechnipFMC ( FTI ).

While IEZ does incorporate small-cap oilfield services stocks, its pronounced allocation to the industry's stalwarts elevates its weighted average market cap to a substantial $25.5 billion. I believe this discernible tilt towards leading oilfield service providers, particularly SLB and Baker Hughes, could be viewed as a positive alignment in the prevailing business climate, potentially boding well for the ETF's performance trajectory.

Market dynamics to benefit IEZ's Holdings

Oilfield services and equipment providers, the core constituents of IEZ's portfolio, find their earnings intrinsically tethered to the oil and gas exploration and production activities, which, in turn, are swayed by the ever-fluctuating oil prices. This year, the oil market's sentiment has been ambivalent at best, causing considerable volatility in prices. The U.S. benchmark WTI crude oil has predominantly fluctuated between $70 and $80 a barrel in 2023, marking a decline from the previous year's average of $90 a barrel.

The physical oil market is currently showing hints of tightening supplies. A recent report from the U.S. Energy Information Administration revealed a drop in crude oil stockpiles by 5.96 million barrels, settling at 439.7 million barrels as of the past week. Commercial crude oil inventories, after peaking at 481 million barrels in mid-March, have mostly followed a declining trajectory. Augmenting this trend is the OPEC+ group, spearheaded by Saudi Arabia, which has curtailed its output since November. Consequently, the group's production plunged to nearly two-year lows in July, as per a Platts survey.

However, the demand side of the equation presents a more unsettling picture. Anticipation around oil demand from China, the world's top crude oil consumer, is becoming increasingly skeptical. Originally projected to be the primary catalyst in driving crude oil demand in 2023, thanks to its post-COVID economic resurgence, China seems to be straying from these expectations. Some of its key economic indicators, such as industrial output and retail sales, appear subdued. In a bid to invigorate its economic growth, Beijing slashed its key policy rate. Yet, this move may have amplified the concerns regarding China's capability to achieve its 5% GDP growth target in 2023. An underwhelming economic performance by China might inevitably ripple into dampened demand for crude oil.

The intricacies of the oil market are evident in the varied responses from producers across different geographies. While oil prices hover at a level that ensures comfortable profit margins for producers, the reactions to the market conditions differ starkly between the U.S. and international terrains.

In the U.S., oil producers have adopted a more conservative stance, concentrating on lifting shareholder returns, instead of boosting production. The inclination has been towards curtailing drilling activities, hinting at a potential moderation in production growth rates. This is underscored by the fact that U.S. shale oil and gas drillers have been steadily decommissioning rigs throughout the year. Baker Hughes data shows a decline in rig count from 772 at the beginning of the year to 654 by the recent week's end.

Contrastingly, the international arena paints a different picture. The national oil companies, such as Saudi Aramco ( ARMCO ), that command significant sway in the global oil market, are ratcheting up their drilling activities. This uptick is particularly pronounced in offshore regions, as these companies align their actions with overarching national energy objectives, encompassing facets like energy security. To quantify this, the international rig count climbed from 900 at the onset of this year to 961 in July, as per data from Baker Hughes. This surge in drilling endeavors is especially noticeable in regions like the Middle East, North Sea, Guyana, and Brazil.

Such a landscape spells potential boons for leading oilfield services firms which are prominently featured in IEZ's portfolio. Giants in the industry, namely SLB, Baker Hughes, and NOV - constituting the top trio in IEZ's portfolio - derive a substantial portion of their revenue and profits from markets outside North America, especially offshore sectors. The latter is currently witnessing heightened activity, rendering a promising environment for these market leaders.

SLB, which holds the top spot in IEZ's portfolio, offers an instructive example of how offshore and international markets are driving success for the large oilfield service providers. The company recently said that it is seeing "positive momentum" emanating from both international and offshore sectors, which is evidently bolstering its performance. The recent quarterly results are a testament to this: the company, with its dominating presence in international markets, reported an impressive 20% YoY surge in revenues coupled with a 44% uptick in adjusted earnings. Two particular regions have been catalysts for this growth - the Middle East and Asia - complemented by robust activities in offshore regions including Angola, Brazil, the US Gulf of Mexico, Namibia, and the Caspian Sea. A major player in the oilfield equipment space, NOV, mirrors this success trajectory, with its revenues and earnings on an upward curve due to the robustness of international and offshore markets-a subject I discussed at length in a previous article .

The leading oilfield services companies, such as SLB, Halliburton, Baker Hughes, and NOV, maintain a global presence and are poised to benefit from the strength in the offshore and international markets. The ongoing deceleration in North America is likely to be offset by their robust international operations. Given their expansive global footprints, it's plausible to anticipate that these companies will persist with their earnings growth, especially as offshore and international drilling activities remain healthy.

I think SLB, in particular, stands out in this context. Nearly 80% of its revenue streams originate from international territories, and intriguingly, half of this is intertwined with offshore markets. This places SLB in an especially advantageous position, poised to capitalize on the prevailing trends more than any of its competitors.

Is IEZ The Best Choice?

IEZ, undoubtedly, offers a compelling exposure to leading oilfield services companies. However, it's essential to highlight that it's not the sole ETF in the market that caters to this segment. Investors have alternatives such as the VanEck Oil Services ETF ((OIH)), Invesco Dynamic Oil & Gas Services ETF ((PXJ)), and the SPDR S&P Oil & Gas Equipment & Services ETF ( XES ).

PXJ and XES adopt a distinct approach, utilizing a modified version of the equal-weighted strategy for their portfolio construction. This results in a relatively uniform weighting among their top-10 holdings. This structure starkly contrasts with IEZ's pronounced concentration in a few significant players. Consequently, with PXJ and XES, investors miss out on the outsized exposure to industry giants such as SLB, Baker Hughes, and Halliburton, and the potential benefits they might reap from the strength in offshore and international markets.

Data source: Seeking Alpha

OIH presents a closer resemblance to IEZ in its portfolio structure. Both ETFs prize SLB as their premier holding and allocate about a fifth of their assets to this leader. Digging deeper, barring Weatherford International ( WFRD ), the rest of IEZ's top-10 assets mirror those of OIH, albeit with variances in individual weightage. For instance, while IEZ's second-largest holding is Baker Hughes, OIH positions Halliburton in that slot. IEZ leans heavily towards SLB and BKR, whereas OIH spreads its preference across SLB, HAL, and BKR, offering a tad more diversification. Hence, for investors keen on leveraging the buoyancy of international and offshore markets through the three leading oilfield services companies, OIH arguably presents a superior proposition.

Moreover, in a head-to-head comparison on size and liquidity, OIH outperforms IEZ. Boasting a formidable $2.43 billion in assets under management, OIH stands as the largest oilfield services ETF on the market. It also registers a robust 3-month average daily share volume of 572,500, earning an 'A' grade for liquidity on Seeking Alpha. In contrast, IEZ, with its roughly $200 million AUM and a daily trading volume surpassing 144,000 shares, settles for a 'B-' liquidity grade. Thus, with its enhanced tradability and tighter bid-ask spreads, OIH could emerge as a more efficient and economical option for investors over IEZ.

Another distinction between OIH and IEZ lies in their respective expense ratios. And here too, OIH comes out ahead with a relatively lower expense ratio of 0.35%. To put that in perspective, for every $10,000 of investment, OIH would levy a charge of $35 annually. In contrast, IEZ, with its slightly elevated expense ratio of 0.40%, will charge investors $40 for the same investment size.

While a mere 0.05% difference might appear negligible at first glance, its impact can become significant when compounded over an extended time horizon. It's an elemental principle of prudent investment: there's little rationale behind paying a premium fee, however marginal, for what could be comparable, if not lesser, exposure to oilfield service equities.

Takeaway

Undeniably, IEZ offers investors a conduit into major oilfield services companies, particularly those well-entrenched to capitalize on the strength of the international and offshore sectors. Names like SLB, anchoring IEZ's portfolio, underscore this positioning. Yet, while IEZ serves as a viable vehicle to harness the momentum of such markets, it may not be the optimal choice. OIH, with its more favorable fee structure and broader diversification, warrants serious consideration for those looking to venture into this space.

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