XOM - DIG - Moving From Sell To Hold On This Oil And Gas Fund

Summary

• ProShares Ultra Oil & Gas seeks results that are 2x the daily performance of the Dow Jones U.S. Oil & Gas Index.
• The ETF is a 2x leveraged play on a portfolio of Oil & Gas equities.
• With recessionary fears being priced into bond yield and oil prices, we recently assigned the name a Sell rating, expecting weaker price action into the new year.
• The China re-opening has put a floor on oil prices and the move lower in DIG was not as substantial as expected.
• DIG is not a buy and hold instrument, but a trading tool, and it should be entered and exited with specific targets in mind.

Thesis

ProShares Ultra Oil & Gas ETF ( DIG ) seeks daily investment results that are 2x the daily performance of the Dow Jones U.S. Oil & Gas Index. In December 2022 we looked at the name and initiated coverage with a Sell rating, expecting weaker WTI prices and weaker Oil & Gas prices into the new year as recessionary fears would take hold. This was set-up as a short-term trade, but unfortunately it did not work to the extent expected. WTI did move down, but bounced off support at $70:

We expected a move down here to a $65 level. It did not materialize, especially with China ending their zero-Covid policy , and the China re-opening putting upward pressure on oil prices.

DIG is a leveraged fund, hence not a product suitable for a buy-and-hold strategy. Please note that leveraged products are fundamentally not buy and hold investments, and come with specific risks as identified by FINRA . For us DIG was meant as a short term play, and that is why we are closing the Sell position here. In this very volatile market leveraged plays can be very profitable at times, if the thesis plays out correctly.

In the past months we have seen a dual factor move: on the one hand oil moved lower (until the China re-opening) and bond yields also retraced substantially. In our mind this was exactly a recessionary play by the market - lower yields and lower oil prices on the back of lower expected domestic demand.

Performance

Oil and Gas equities did not sell-off as expected:

We have mapped the Oil ETF ( USO ) above, as well as the Oil & Gas Sector Fund ( XLE ) in conjunction with DIG. The fund did spend some time in negative territory given its leverage nature, but has now re-bounded. It is important to remember that this fund, just like any leveraged product is to be traded with set entry / exit targets in mind. Again, this name is not a buy and hold name. For us the target was a $65 WTI price, which failed to materialize.

Holdings

The ETF synthetically matches via swaps the Dow Jones U.S. Oil & Gas Index . Its composition is as follows:

We can see its composition is quite reminiscent of XLE's, with Exxon ( XOM ) and Chevron ( CVX ) accounting for a very large proportion of the index (over 39% currently). Having a leveraged exposure simply means the ETF provides for 2x of the underlying index returns. Magnified returns work both ways - they can provide for very rewarding up years, but also can wipe out an investor's capital during down years. Leveraged products are to be used as shorter-term trading tools rather than anything else.

Speculative Account Positioning

One of the pillars of our thesis was the speculative account positioning in oil:

We can see that market participants who actively trade the futures market in oil are at very light historic levels. Rather than a contrarian indicator we were using this as a leading one - i.e. speculative account positioning in futures is going to drive spot prices.

There are a couple of forces at play here - macro wise, we believe we are in a multi-year bull market in energy, so energy equities are going to do well over the upcoming years. Short-term however, we do think the current recession is not fully priced in. While bond prices/yields are correctly reflecting a decelerating economy, oil prices did not 'puke', but actually found a nice support at a $70 price level. Considering many of the oil and gas stocks in DIG have break-even prices in the 30s for oil production, oil equities are still amassing substantial profits even at $70 oil.

Conclusion

DIG is a 2x leveraged play on a portfolio of Oil & Gas equities. We assigned the fund a Sell rating in December expecting weaker oil prices into the new year on the back of recessionary fears. While we saw the expression of that macro trend in lower bond yields, oil got a positive boost from the China re-opening story. From a macro stand-point we do feel oil is in a multi-year expansionary cycle, but it will have months long down-turns. Our call was also motivated by the strong bearish sentiment in the wider equity markets, with many analysts expecting a substantial leg down in the January - March period. Those calls did not materialize and it looks like WTI oil is building a base around the $70 support level. Given break-even levels for the underlying equities are in the 30s for oil, the respective enterprises are going to keep posting healthy net income figures even with WTI oil at $70.

For further details see: