IEO ETF: Following Macroeconomic Threads Makes Us Wary Of Oil (BATS:IEO)

The iShares U.S. Oil & Gas Exploration & Production ETF (BATS:IEO) is mostly exposed to commodity prices of oil. We discussed the supply cuts in our previous coverage. While the Libya situation gives some reprieve, the combination of a weaker Chinese economy, concerns about capital and inventory investment in the US manufacturing sector, and of course, the telegraphed supply cuts in oil would have us looking elsewhere for the moment, unless there are specific reasons to make a pick. Direction is the issue.

IEO Breakdown

The IEO follows mostly E&P companies that are going to have some midstream assets but are ultimately exposed to the situation in oil markets and the price of oil.

On an explicit basis, 75.5% of the assets are allocated to oil & gas E&P stocks. Exxon Mobil (XOM) doesn’t feature, although stocks like ConocoPhillips (COP) and the once integrated downstream and midstream COP assets spun off into Phillips 66 (PSX) are also included in the ETF. There is around a 25% exposure to logistics stocks associated to oil and gas. Phillips 66 as an example would be in this number. There aren’t too many of the integrated oil majors in the ETF, making IEO a little bit unusual relative to a more value weighted and broader scope oil ETF.

The bottom line is though that 75% or so of the portfolio depends directly on the price of oil. The remaining portfolio depends on spreads that depend directly on the end-market demand areas of crude. We think industrial concerns lie at the centre of a more cautious outlook on oil, which affect both clearly.

Macro Considerations

There are several macro considerations, the first being that China is struggling to recover economically. The real estate industry there is particularly structural to economic activity, impacting a disproportionate amount of household perceived and actual wealth, both through asset values as well as a depression in activity that employs a large part of the economy. China is a large industrial end market, and a contraction in the local economy, which is a large consumer economy even if China is more export focused, is a concern for oil which is an input to all industrial activity in one form or another. At least in China the export and producer situation could be worse in terms of profits, with signals pointing to producer profit increases despite geopolitical and trade considerations, as well as worries about the local Chinese economy.

Industrial markets are also a concern in the US, the cause of yesterday’s correction. The minority are reporting an expansion of purchasing activity in the ISM monthly survey. That doesn’t necessarily mean contraction, and it is up MoM, it is a concern that US economic activity on an underlying basis may not be as strong as hoped. There is an unwillingness it seems to make CAPEX commitments and build inventory levels, which, whether rational or not, both predicts and reflects an environment that lacks confidence in the economy. This data being directly related to producers is a slight concern as it would mean something for the demand side of oil as well.

Bottom Line

Demand side considerations are pretty important right now for the trading of oil. Until now, the supply cuts that became ever more aggressive by OPEC+ protected the commodity from downside even as uncertainty around the global economy, China, of course, included, began to mount. Oil prices will be even more sensitive to the demand side as the supply cuts are telegraphed to be coming to an end with the rollbacks starting soon.

However, elements of our thesis of robust oil prices have come to pass. We considered that despite the lack of a specific supply side catalyst to oil, some were going to be inevitable due to the geopolitical tensions and the tendency for oil supply chains to be targeted and affected. In this case, it is a dispute between different governmental factions in Libya, where one used their authority to suspend Libya’s significant production at the key El-Feel oil field.

Nonetheless, we think the lack of confidence by consumers and producers spells trouble for oil as the supply cuts get rolled back. China is the more definitive concern for the industrial end markets, and while not damning, the US market is also showing lack of vigour. The EU is also seeing decreased industrial output.

The latest market tremors have been reflected in the correction in oil stocks. The 8.5x PE reflects the concerns over oil and demand. We are concerned about direction. We think selectivity makes sense in oil to have another determined source of margin of safety.