IXC - IXC: Realize The Profits Before Reality Sets In

Summary

• IXC has significantly outperformed the market in the past year. However, the oil market cycle is now moving into a less favorable phase for the ETF.
• Energy stocks, which make up the entire portfolio, are yet to reflect the bearish trend. However, the moment of truth is inevitable.
• The pricing of IXC follows that of oil. The macroeconomic scenario suggests that the peak of the the commodity price in this market cycle was already reached in 2022.
• I believe that in the coming months, the ETF will start to follow the performance of oil, losing some of the gains made in 2022.

The iShares Global Energy ETF (IXC) has recorded a positive performance of 21.49% over the past year, in contrast to a 7.07% decline for the S&P 500 index. Given the outlook for the oil market, to which all companies in which the fund has invested belong, it appears that it is now time to realize profits and move on. The valuations of oil companies will soon have to align with the declining barrel price and the economic cycle. My outlook is bearish, especially for 2023.

The energy sector was the true winner of 2022, having benefitted from the perfect storm of events: the gas crisis in Europe following the invasion of Ukraine, the low production level of OPEC, rising inflation, and the revival of transportation after the pandemic. Just when it seemed that the situation had stabilized with the price cap introduced by the European Union on Russian oil prices, China suddenly reversed its zero-COVID policy.

The iShares Global Energy ETF naturally benefited, closing the year with a performance exceeding 40%. Shareholders also received dividends of $1.857 during the year, a 69% increase over 2021. However, the sector has always been highly cyclical. After a year of glory, it appears that there is no longer any potential upside to be found anywhere.

Overview of the ETF

The iShares Global Energy ETF holds 52 stocks in its portfolio, closely tracking the performance of oil prices. The current market cap stands at 2.1 billion dollars and the top 10 holdings are:

1. Exxon Mobil (16.63%)
2. Chevron (11.69%)
3. Shell (7.28%)
4. TotalEnergies (5.64%)
5. ConocoPhillips (5.38%)
6. BP (3.82%)
7. Enbridge (2.90%)
8. EOG Resources (2.79%)
9. Schlumberger (2.77)
10. Canadian Natural Resources

The fund is exposed to the entire oil value chain , from exploration to refining. Many of the companies in the portfolio have a global reach, with 60.78% exposure to the United States and the rest distributed among Europe, Canada, Australia, and Brazil. The management fee is 0.40% , in line with the Vanguard Energy Fund Inv (VGENX) and slightly higher than the 0.30% of the Lyxor MSCI World Energy ETF.

Essentially, this is a product designed to provide exposure to the oil market, with the advantage of holding instruments that generate cash flows. Up until 2020, the performance of the fund and that of oil had been largely in sync. However, from 2021 onwards, there have been significant divergences , which are also the basis for my short-term bearish outlook.

IXC - Investment strategy

IXC is a passive fund that aims to reflect the performance of the S&P Global 1200 Energy Index . The index encompasses all companies that S&P Dow Jones Indices LLC considers impactful for the global energy market trend. The fund does not attempt to outperform the index, but rather follows it through a "representative sampling" strategy. The managers are tasked with constructing a portfolio of stocks representative of the entire index, without having to purchase all the constituent companies.

In theory, IXC could restrict itself to investing 80% of its portfolio in the companies that are part of the index and could limit itself to buying only a representative sample. In reality, the fund currently holds the same 52 companies that make up the index and each weight is identical . Only 0.2% of the fund consists of other assets, such as cash or capital invested in the money market.

Benchmark, analysis and alternatives

The ETF's performance has been slightly better compared to the benchmark, both recently and over its history. After adjusting the results to account for fees, the fund's net return was 0.1% lower compared to the index.

The current P/B ratio of the portfolio is 2.04, slightly lower than the 2.25 measured by the NYU Stern School of Business in January for the entire integrated oil and gas sector. The P/E ratio is 10.93, which may seem low but is essentially linked to the very high oil prices in 2022.

Dividends are paid out twice a year, and the total annual distributions over the past 5 years are reported in the table below.

The next table lists the most popular alternatives to this ETF along with their key features and past performance:

The most similar ETF in terms of investment strategy is NRGW, while VGENX is an actively managed ETF that has changed its benchmark multiple times over its history (currently it is the MSCI All Country World Energy + Utilities Index). With a market capitalization of $15.6 billion, XLE is definitely the largest: the main difference is that this ETF only provides exposure to US companies, while the other funds have a global coverage. Given the strong recovery of American shale oil in 2022, it is the ETF that performed best among the four analyzed over the last year.

Why I am bearish on IXC in the short term (6 months)

To begin with, it is important to analyze the historical performance of this ETF in relation to the oil price. Over the past 5 years, as one would expect, for most of the time the performance of one has been similar to the performance of the other.

In 2021, the price of the commodity began to grow faster than that of the stock, most likely because investors expected the rise in oil prices to be temporary. These were still the good times when most analysts expected inflation to be a temporary phenomenon, destined to last a few months. It was also not yet clear what impact the invasion of Ukraine would have on gas and oil supplies in Europe.

Essentially, I am bearish on the iShares Global Energy ETF in the short term because the gap between the price of oil and the price of energy stocks has been largely bridged. Over the past few months, the price of oil has decreased by 34% while the price of IXC has only lost 3.98%.

This means that the two are now aligned, and if the price of oil doesn't see another unexpected increase, the energy stocks may have to follow the downward trend of the commodity. There are only two possible scenarios: either the price of oil will see another unlikely boom and push the energy stocks up, or the stocks will have to align with the downward trend that has already affected the commodity.

Why I have a bearish outlook on IXC in the mid-to-long term (1-3 years)

The oil market, and even more so the oil stock market, are cyclical in nature. A brief look at IXC's returns over time further highlights this aspect. Investors' attitudes are equally cyclical, with moments of utter despair - as seen with the negative futures in 2020 - and moments reminiscent of the oil enthusiasm of John D. Rockefeller's era.

The fact that the value of oil stocks is at its highest point in the last 10+ years already suggests that, given the cyclical nature of the market, valuations may be overstretched. Upon closer examination of the fundamentals, this becomes even more evident. Both the demand and supply sides have contributed to a rise that, today, no longer has fuel to continue.

Demand side

The real GDP is forecast to decrease by 0.2% in 2023 and by 0.3% in Europe . Typically, oil demand tends to amplify the fluctuations of the real economy, so we can expect that demand will not increase much throughout the year. Furthermore, markets have probably already discounted the recovery of demand in China, so we are not facing many variables that could lead to an increase in crude oil demand beyond expectations.

We also know that high interest rates harm demand for goods that are usually purchased through financing, such as transportation means. In addition, consumer confidence has decreased by 35+% compared to pre-pandemic levels, another factor that does not suggest a surge in consumption.

Offer side

The OPEC+ Joint Ministerial Monitoring Committee has recently reiterated its recommendation to maintain current production levels. Currently, export levels are already at a decade low, as data from the cartel itself shows.

Meanwhile, the European Union has set a precedent by imposing a ceiling on the price of Russian gas. For the first time, a "buyers' cartel" has been opposed to the producers' cartel. After the announcement of the decision, the price of oil accelerated its downward trend.

In the meantime, Kazakhstan has started to break away from the need to transport oil through Russia, Guyana has effectively become an exporter of this commodity, and the global market is finding a rebalancing after the chaos caused by the invasion of Ukraine. Many of the actions in the iShares Global Energy ETF have suffered from the imbalance in the supply chain in 2022, when European nations had to quickly find suppliers to replace Russia as much as possible.

It is still possible that OPEC may decide to reduce its production levels, but at this point someone may start thinking of extending the logic of the price cap to other suppliers as well. Europe and the United States are fighting a fierce war against inflation and will hardly let oil exporters cause another surge in price pressure.

Risks and considerations

Many of the recent articles published on Seeking Alpha regarding IXC present a bullish view. However, it must be noted that, until December 2022, the conversation topics regarding oil were different from the current ones. It was not yet clear if the European ceiling on oil prices would work and China had just announced the end of the zero-Covid policy.

Today, the market has had ample time to price in the Chinese government's decisions, while the European common line has proven effective in lowering oil prices. It is even possible that this technique, after proving effective once, may become a common tool to empower oil-importing nations.

At the last FOMC meeting, Powell also made it clear that interest rate hikes are set to continue for several months. Quoting the Fed Chairman, "These are still very early stages of disinflation". The oil market is short of good news that can lead to a further increase in demand or a drop in supply. Instead, economic activity seems almost certain to decline, leading to a decrease in demand, as the supply chain is recovering leading to fewer imbalances on the supply side. Simply recognizing when a cycle has reached its peak is important.

Another important factor supporting my bearish thesis is the high valuation of energy companies. The P/E ratio of these companies is not that indicative, as it almost solely depends on the price of oil. However, looking at the charts of the P/B ratios of the most represented companies in the IXC portfolio, it is clear how valuations are high compared to their historical average.

The only reason I might return to a bullish outlook on IXC would be a major unexpected event on the macroeconomic front. Possible unexpected events for 2023 could be:

• A growing GDP in the United States and Europe (>0.2%) contrary to expectations;
• A surge in demand for oil in China, on the back of much higher growth than expected;
• The decision by Russia to completely block or significantly reduce oil exports.

All three scenarios are far from the most likely, so I do not consider these risks sufficient to overturn my bearish outlook.

Conclusion

IXC must contend with falling oil prices and a macroeconomic scenario that does not suggest a change of direction. Given that this ETF has historically closely followed the price of the commodity, I believe that the divergence of these months will be bridged and that the stock price is destined to decline.

The catalyst will probably be the Q1 2023 quarterly data of energy companies, when it will be possible to evaluate the impact of lower oil prices. In the meantime, it is very likely that the ETF will experience underperformance compared to the broader market, considering that other sectors that were penalized during 2022 now show more attractive valuations.

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