XOP - M&A Heats Up In The Oil Patch XOP A Buy On Valuation Diversification

2023-10-23 14:00:23 ET

Summary

• Chevron acquires Hess for $53 billion in an all-stock deal, following Exxon Mobil's acquisition of Pioneer Natural last month.
• Chevron plans to increase its dividend by 8% in January and expects the deal to generate significant free cash flow by 2025.
• The SPDR S&P Oil & Gas Exploration & Production ETF is recommended for investment due to sustained elevated oil prices and diversification benefits.
• I outline key price levels to watch on XOP as year-end approaches.

There's more M&A activity in the oil patch. Following Exxon Mobil's (XOM) acquisition of Pioneer Natural (PXD) earlier this month, Chevron (CVX) has agreed to buy Hess (HES) for $53 billion, or $171 per share, in an all-stock deal. Chevron plans to increase its dividend by 8% in January and sees the move as very free cash flow generative as soon as 2025, with FCF potentially doubling by 2027. Let's focus on the oil and gas E&P space. Both PXD and HES are components of one popular Energy sector fund.

I have a buy rating on the SPDR S&P Oil & Gas Exploration & Production ETF (XOP). Sustained elevated oil prices, amid geopolitical uncertainty and commodities offering some diversification benefit, make the space attractive. A key risk, though, is that the economy could be in a late-cycle environment, which usually is not a great period for risk on oil and gas stocks.

Energy E&P Stocks Rally Versus the SPX Since June

While the Recent Jump in Oil Concerned Some Investors, Higher Oil Prices Have Historically Helped S&P Earnings

According to the issuer , XOP seeks to provide exposure to the oil and gas exploration and production segment of the S&P total market index, which comprises the following sub-industries: Integrated Oil & Gas, Oil & Gas Exploration & Production, and Oil & Gas Refining & Marketing. The fund's modified equal-weighted approach provides the potential for unconcentrated industry exposure across large, mid, and small-cap stocks.

XOP is a large ETF with $3.8 billion in assets under management and its expense ratio is modest at just 0.35%. With a trailing 12-month dividend yield of 2.34%, the distribution rate is significantly higher than that of the S&P 500. The ETF also features robust stock-price momentum , which I will detail later, though there is considerable risk with the fund - particularly if a global economic slowdown hits oil prices. Still, geopolitical unrest in the Middle East could help support WTI and Brent on pullbacks over the coming weeks and months. Finally, liquidity is strong with XOP - its average daily volume is more than 4.5 million shares, on average, over the past three months, and the ETF's 30-day median bid/ask spread is narrow at a single basis point.

Digging into the portfolio, data from Morningstar show that XOP has high exposure to small-cap value. While the fund holds many large-cap stocks, its modified equal-weight constructive methodology gives a relative overweight to small-sized firms - amplifying the cyclical risk. Moreover, XOP differs considerably from the S&P 500 in that just 10% of the ETF is growth, so expect XOP to offer differentiated returns compared to the broader market.

Investors should like the earnings quality of the fund's holdings. The industry's price-to-earnings ratio is in the single-digit and the ETF's components generally feature very impressive free cash flow and capital discipline. There's a diversification benefit with the fund in the sense that the top 10 holdings account for just 26% of XOP's total assets.

XOP: Portfolio and Factor Profiles

XOP: Holdings and Dividends

Seasonally, XOP tends to limp into the end of the year, according to data from Equity Clock . There's on average a rally from late August through early November, but then the fund often underperforms the broader market when usual seasonal strength helps the S&P 500 through December and the first few days of a new year.

XOP: Lackluster Seasonal Trends Into Year End

The Technical Take

XOP is now beating the S&P 500 on a year-to-date basis. That's impressive considering how strong mega-cap tech has been. Still, the ETF remains under its June 2020 high when oil prices were at their peak following Russia's invasion of Ukraine. After a significant drawdown over the ensuing few weeks, XOP has meandered, but there have been positive technical developments.

Notice in the chart below that XOP rallied above its long-term 200-day moving average back in Q3, then the bulls defended that level on a test earlier this month. On the bearish side of the ledger, we see that there's a negative RSI divergence between momentum and price - the RSI indicator at the top of the graph shows lower highs as the fund rose and then put in a near-term double-top pattern. I see support near $135 with another area of support in the $108 to $116 range. A rally through $155 would suggest a measured move price objective to $174 based on the $20 height of the recent pullback.

Overall, with high relative strength since mid-June and decent technical moves over the last handful of months, XOP looks decent on the charts.

XOP: Long-Term Support Near $110, Near-Term Double Top

The Bottom Line

I have a buy rating on XOP. Its low valuation, diversification, and solid technicals look good to me, while seasonality and macro risks remain apparent.

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