VLO - FENY: Fidelity's Energy ETF Is Good For A Trade

2023-08-11 13:14:16 ET

Summary

• The Fidelity MSCI Energy ETF (FENY) provides cost-efficient exposure to major oil, gas, and refining companies.
• The global macro-economic environment is uncertain, posing demand risks, but supply-side factors such as Saudi Arabia's production cuts support oil prices.
• The FENY ETF currently yields 3.36% and is well positioned to benefit from what I expect to be strong oil and refining markets in the second half of this year.
• That said, it's instructive for investors to consider FENY's long-term under-performance relative to the broad market averages like the S&P500 and Nasdaq-100.

The Fidelity MSCI Energy ETF ( FENY ) is a relatively cost-efficient (0.084%) way for investors to gain diversified exposure to the biggest U.S. oil-and-gas companies. Currently, the global macroeconomic environment is rather uncertain, in my opinion, so from a demand perspective there appears to be some risks. However, on the supply side, Saudi Arabia continues to hold millions of barrels-per-day ("bpd") off the market and U.S. shale producers continue to be relatively disciplined - although the U.S. remains the No. 1 petroleum producing country on the planet. Regardless, WTI appears to have bottomed this summer and is currently trading at a high for the year as we head into winter (see chart below). Refining margin - especially for diesel - remains strong. As a result, I rate the FENY ETF, which yields 3.36%, as a Buy for a short- or perhaps even mid-term trade.

Investment Thesis

I have covered the FENY ETF extensively on Seeking Alpha and the ETF has more the doubled the returns of the S&P 500 since my BUY rated article last July (see FENY: Fidelity's Energy ETF Is A Buy On Market Pullback ). In December, I cut my rating to HOLD as the macro-environment had changed, and I saw lower prices on the horizon. Indeed, since that time, the S&P 500 roughly doubled the returns of the FENY ETF.

Today, the environment has turned again: WTI is currently trading at a high for the year after Saudi Arabia announced it would continue its previously announced 1 million bpd production cut through September while an unnamed source was quoted as saying the cut may be "extended, or extended and deepened." Shortly after the Saudi announcement, Russia chimed in by saying it would cut oil exports by 300,000 bpd in September.

This week's EIA petroleum status report signaled a 5.9 million bbl build in U.S. commercial crude inventories - which are now slightly below the five-year average. However, distillate fuel inventories are 17% below the five-year average and jet-fuel demand has been strong - up 4.3% over the four-week average one year ago.

Meantime, and despite the false narrative that somehow the U.S. is not energy independent and that President Biden would "kill" the domestic energy industry, U.S. crude oil production continues to bounce strongly off the low set during the pandemic:

Indeed, last week, U.S. crude oil production was 12.6 million bpd - only 500,000 bpd away from the all-time high of 13.1 million bpd set in February 2020 prior to the pandemic slamming into the U.S.

And, as I reported previously on Seeking Alpha, the U.S. became the world's No. 1 LNG exporter last year, and domestic natural gas production is currently at an all-time high :

So, we're at or near record total petroleum production in the U.S. and that's being rewarded by a relatively strong oil price. The combination means strong free cash flow for U.S. shale oil producers in the second half of this year. That being the case, let's see how the FENY ETF has positioned investors for success going forward.

Top 10 Holdings

The top 10 holdings in the FENY ETF are shown below and were taken directly from the Fidelity FENY ETF webpage where investors can find more information on the fund.

As can be seen in the graphic, FENY has a total of 35.7% of the fund's capital in the top-two U.S. O&G companies: Exxon ( XOM ) and Chevron ( CVX ). Both companies have international integrated operations as well as strong growth profiles in the Permian Basin. For instance, in Q2 Exxon grew its Permian and Guyana production by 20% yoy . Chevron grew its Permian production 11% yoy to 772,000 boe/d . As the slide below shows, Chevron has over 6,600 drilling locations in the Midland and Delaware Basins and plans to grow production to well over 1 million boe/d by 2030 and then hold it there for at least a decade:

Exxon and Chevron both throw off decent income, with XOM currently yielding 3.4% and Chevron 3.8%. However, both companies also are greatly over-emphasizing share buybacks over dividends directly to investors.

ConocoPhillips ( COP ) is the No. 3 holding with a 7% weight. COP has been an excellent performer over the past three years and has outperformed its two bigger international integrated peers by a significant margin:

Unlike both Exxon and Chevron, COP has implemented (base+variable) a dividend policy that in aggregate has returned $4.54/share to investors over the past four quarters. That equates to 3.9% yield. COP's Q2 Permian production was 709,000 boe/d .

Refining is well represented within the FENY portfolio with Marathon Petroleum ( MPC ), Phillips 66 ( PSX ), and Valero ( VLO ) having a total allocation of 9.1% of the entire portfolio. These stocks have been very strong of late as the market has realized that refining margins are high, especially for diesel. Phillips 66, the largest importer of Canadian heavy crude, has a higher distillate yield as compared to its peers and here is what Brian Mandell, in charge of Marketing & Commercial business at PSX, said on the Q2 conference call :

On distillate, we have the demand down a bit in the U.S., mostly on industrial manufacturing segments. But globally, we have it up. We have lots of pockets of really strong distillate demand in Latin America, up 9%, Asia up 4% and diesel cracks continue to remain strong . In fact, they've gotten a lot stronger and we believe that they'll continue to perform throughout the year as we head into higher demand planning season and into winter in the U.S. where distillate over gasoline every pad now.

Performance

While the FENY ETF has been performing well of late, note that its five-year total returns are relatively poor (note the "market returns" represents the energy markets FENY is directly comparable to, not the broad market like the S&P 500):

This is a reminder to overly bullish O&G investors that oil can go down, just as easily as it can go up (i.e., it's a global and cyclical commodity market).

The graphic below compares the five-year total returns of FENY with some of its direct competitors - the Vanguard Energy ETF ( VDE ), the iShares US Energy ETF ( IYE ), the SPDR Select Energy ETF ( XLE ) - as well as the iShares Global Clean Energy ETF ( ICLN ) and the broad market averages as represented by the Vanguard S&P500 ETF ( VOO ) and the Invesco Nasdaq-100 Trust ( QQQ ):

As can be seen, the FENY ETF is near the bottom of the group while the QQQ and ICLN ETF are at the top. Meantime, the S&P 500 significantly outperformed all the O&G centric ETFs. This is another reason for oil bulls to not get overly enthusiastic over the long term.

Risks

The primary risks for buying and holding the FENY ETF for the long term are considerable, in my opinion. Not only are the oil markets volatile and cyclical, but - in my opinion - we live in an era of energy abundance (see Investing In The 'Age Of Energy Abundance' - EVs, Renewables, and O&G ). Indeed, US shale producers are sitting on billions of bbls of proven reserves that could very easily and very profitably be drilled, lifted, and brought to market on existing infrastructure. Meantime, Exxon is ramping up Guyana production, and we still have multiple millions of bpd of Saudi production being held off the market.

In addition, the U.S. "big 3" O&G companies (XOM, CVX, and COP) are all over-emphasizing share buybacks over dividends directly into investors' pockets. As a result, they're effectively forcing shareholders to double down on the future of O&G in the age of the clean energy transition and EVs. Meantime, all three are refusing to allocate any capital to wind, solar, or battery backup capacity.

Summary and Conclusion

The FENY is well positioned to benefit from a higher-priced oil environment expected in the second half of this year and as we head into winter. Refining margins are also quite robust. That being the case, and considering its 3.36% yield, I rate FENY a BUY as a short- to mid-term trade.

However, longer-term I'm not convinced that an O&G centric ETF like FENY will deliver superior returns as compared to the broad market averages. Investors should not forget that during the "lost decade," Exxon - the No. 1 holding in this ETF - actually delivered a negative total return. That, of course, is why Engine #1 received so much support from institutional and professional money managers that were exasperated with Exxon's CEO and the company's very poor returns (see How Tiny Engine #1 Was Able To Turn Exxon Around ). That said, Exxon's CEO virtually scrapped his entire "strategic plan" due to pressure from Engine #1, and today Exxon is a much more efficient company and is much more focused on its crown jewels: Guyana and the Permian.

I'll end with a 10-year chart comparing the total returns of Exxon versus the broad market averages and the chart speaks for itself:

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