PXJ - PXJ: Championing The Underdogs Might Be A Misstep

2023-06-26 12:36:17 ET

Summary

• The Invesco Dynamic Oil & Gas Services ETF is the smallest ETF in the oilfield service providers sector, with a focus on smaller companies.
• PXJ's portfolio construction offers more diversification than larger ETFs like OIH, but its strong lean towards small-caps may be its downfall in the current market conditions.
• With drilling activity rising in international markets but declining in the US, investors may be better served by top-heavy funds like OIH that concentrate on industry giants.

If you've been following my work, you might recall that I recently discussed the VanEck Oil Services ETF ( OIH ) in a previous article . It's the big kahuna in the ETF world when it comes to oilfield service providers, boasting the highest assets under management in the sector. Today, I want to shift gears a bit and talk about the other end of the spectrum - the Invesco Dynamic Oil & Gas Services ETF ( PXJ ), which happens to be the smallest ETF in this domain.

The two ETFs contrast starkly in their portfolio structures. OIH, the more considerable ETF, leans towards being less diverse and tends to back the big guns of the industry - those influential giants dominating international markets. On the flip side, PXJ, our smaller ETF, places its bets on smaller oilfield service companies - those typically overlooked by OIH's radar.

However, I think this championing of the underdogs could be PXJ's Achilles' heel. The current market conditions make me suspect that this very exposure to smaller players might be what causes PXJ's downfall. So, if you're an investor looking for a smart move right now, you might want to give PXJ a wide berth. Stick around, and I'll delve into why I believe this is the case.

About PXJ

The Invesco Dynamic Oil & Gas Services ETF aims to offer investors access to 30 of the leading US-based oilfield services companies. Despite having a significantly lower asset under management at $32 million compared to its counterparts - the VanEck Oil Services ETF, SPDR S&P Oil & Gas Equipment & Services ETF (XES), and iShares U.S. Oil Equipment & Services ETF (IEZ), which manage $2.15 billion, $266.4 million, and $175.7 million respectively - PXJ still displays commendable liquidity. As indicated by its daily trading volume (3-month average) of 430,000 shares, it even surpasses its larger peers XES (127,000 shares) and IEZ (271,000 shares).

Distinct Portfolio Construction

I think what distinguishes PXJ is its portfolio structure, providing investors with access to both prominent and relatively smaller oilfield service providers. Unlike OIH and IEZ, which are predominantly weighted towards large-cap stocks and allocate approximately 40% or more of their assets to their top three holdings, PXJ doesn't show this bias. This means PXJ doesn't favor two of the world’s largest oilfield service companies Schlumberger ( SLB ) and Halliburton ( HAL ) over others.

Contrarily, PXJ doesn't follow an equal-weight strategy either. It categorizes the oilfield services stocks into two sections - larger companies and smaller companies. The larger companies account for roughly 40% of the weight (usually with eight stocks receiving an average of 5% each), while the smaller companies hold 60% of the weight (typically with 22 stocks each possessing about 2.73%).

The top eight stocks that account for roughly 40% of PXJ’s assets are shown in the table below.

The aforementioned table primarily shows large-to-mid-cap oilfield services stocks. The other 22 stocks, which are mostly small-cap, comprise approximately 60% of the ETF's assets. Due to PXJ's portfolio construction method that broadly segregates stocks into small and large groups, investors are exposed to a blend of large-to-mid-cap and small-cap oilfield services companies. The balance between these groups is rather even, with mid-to-large-cap stocks accounting for a total weight of 52% and small-caps representing 48% of PXJ's assets. Moreover, the table reveals that no individual company holds a dominant position in the ETF.

This contrasts sharply with ETFs like OIH, where mid-to-large cap stocks constitute a vast majority of the fund's assets, and the top holding, Schlumberger in OIH's case, represents approximately 20% of the ETF's assets.

Thus, PXJ offers considerably more diversification than OIH. If, for example, Schlumberger's shares were to decline due to weaknesses in international markets, this could negatively impact OIH's performance, but PXJ would remain largely unaffected. Additionally, PXJ's strong lean towards small-caps can afford its investors increased exposure to high-quality small companies, such as RPC, Inc. (RES), typically overlooked by large-cap focused ETFs like OIH.

In my view, this diversification undeniably stands as one of PXJ's strengths. However, a pertinent question arises - should investors currently prioritize diversification, with ample exposure to small-caps, or would they be better served by top-heavy funds that concentrate mainly on industry giants?

Focus on the Industry Titans

A significant distinction between small-cap oilfield equipment and service providers and their large-cap counterparts is their earnings source. Small-caps predominantly derive their earnings from the US, while large-caps tend to get most from international markets. Consider RPC, one of my favored small-cap oilfield services stocks, as discussed in my previous articles ( here and here ). Almost all of RPC's revenues are US-based. In Q1-2023 , out of its total revenues of $476.7 million, $469.4 million, or 98.5%, originated from the US.

This contrasts greatly with industry leaders like Schlumberger. In Q1-2023 , Schlumberger obtained nearly 22% of its revenues from the North America region, while the rest – 78% – came from international markets. The Middle East, in fact, was its largest revenue-generating region, contributing a little over 30% of its Q1 revenues. For Halliburton, North America remained its most significant market, providing 49% of its Q1 revenues, but more than half of its revenues came from international markets, with the Middle East being the most prominent contributor.

Investors can gain substantial exposure to international markets through top-heavy ETFs like OIH, which Schlumberger significantly influences. In contrast, PXJ, which leans towards small caps like RPC, offers investors greater exposure to the US land and offshore markets.

Over the past few years, both US and internationally-focused oilfield service providers have experienced a demand surge as oil and gas producers boosted their exploration and production activities. According to Baker Hughes' data , the worldwide rig count climbed from less than 1,200 rigs in January 2021 to more than 1,900 in February 2023 as producers deployed more rigs domestically and internationally.

Data: Baker Hughes (link provided earlier)

However, this upward trend in rig count appears to be reversing. The worldwide rig count has now decreased for three consecutive months, sliding from 1,921 units in February to 1,879 in March, then 1,808 in April, and finally 1,783 in May. Though we've observed dips before, as illustrated in the above image, the decline has never persisted for more than two months during the ongoing upcycle.

A detailed examination of the rig count data further exposes that the US market drives this weakness. The rig count is still on the rise in international markets. The US monthly rig count has dropped from 772 rigs in January to 728 rigs in May, while in the same period, the international rig count has increased from 901 rigs in January to 965 rigs in May. Baker Hughes' weekly data suggests worsening conditions in the US, with the rig count dipping to 682 rigs for the week ending June 23. For the first time since July 2020, US oil and gas producers have withdrawn rigs for eight straight weeks.

This decline in US drilling activity might be attributable to the US oil and gas producers' heightened focus on enhancing shareholder returns, rather than aggressively expanding production. In contrast, national oil companies such as Saudi Aramco, who dominate the international markets, have increased E&P efforts to bolster their energy security and meet national targets. Internationally focused service providers like Schlumberger and Halliburton are experiencing robust growth in the international market, with Halliburton anticipating a "high teens" increase in spending on oil and gas projects this year in key regions around the world, particularly in the Middle East, Asia, and Latin America.

In the current environment, I believe the industry titans like Schlumberger, with operations across the globe and leading positions in several international markets, are better poised for growth than US-focused small-cap operators. Consequently, investors could benefit more from heightened exposure to industry leaders than to smaller operators. This type of exposure can be obtained through top-heavy funds like OIH, but not PXJ.

Takeaway

PXJ's unique portfolio construction methodology, which apportions roughly 40% weight to larger oilfield services companies and 60% to smaller ones, stands out. In contrast to top-heavy funds like OIH that favor industry leaders, particularly Schlumberger, PXJ only assigns a 5% weight to each large company, while small-caps receive nearly 50% of the weight. However, in the current climate in which drilling activity is rising in the international markets but declining in the US, this limited exposure to industry leaders and a strong bias for smaller companies could work against PXJ. Therefore, I believe PXJ may underperform in the future compared to OIH. As such, I recommend investors steer clear of PXJ.

For further details see: