Looking for Strength Among Energy ETFs

Energy sector exchange traded funds have been battered in recent months, but one advantage of the sector’s struggles is the opportunity investors now have to assess which ETFs are home to stronger energy names and which funds house weak links.

Highly levered exploration and production companies whose ability to generate cash was challenged when oil was around $100 per barrel are being crimped further as oil wilts. Oil’s decline is stoking fears that smaller E&P firms, which have made up an increasing share of the U.S. junk corporate bond market in recent years, could trigger a raft of credit defaults. [Junk Bond Warnings From the Energy Patch]

“Cash is king. In other words, how close is the company to generating excess free cash flows? A company that currently is seen as generating positive free cash flows in 2015 (where estimated cash from operations exceeds estimated capital spending) is probably more likely to stay the course on spending, or trim at the edges, because it has more wiggle room for downside to those estimates. To some degree, it can spend through free cash flow deficits with incremental borrowing, especially if the cost of borrowing is low as it is today. The names that are in worse shape are more likely to make significant cuts,” said S&P Capital IQ in a recent research note.

The SPDR S&P Oil & Gas Exploration & Production ETF (NYSEArca: XOP), an ETF that equally weights a collection of mid-sized and smaller E&P firms, has tumbled nearly 33% over the past three months. That decline overshoots that of the United States Oil Fund (NYSEArca: USO) by more than 500 basis over the same period.

Over 70% of XOP’s weight is allocated to E&P firms and the ETF features exposure to Pioneer Natural Resources (NYSE: PXD), Energen (NYSE: EGN) and Bill Barrett (NYSE: BBG), each of which S&P Capital IQ views as riskier among E&P name. [Oil ETFs Continue to Languish]

“Keep in mind, for this latter subset, weak oil prices can be mitigated if these companies had the good foresight to hedge out future production in recent months. Of course, should weak oil prices persist, the availability of trading partners at attractive hedge prices dries up,” said the research firm.

S&P Capital IQ is more constructive on larger E&P names, including ConocoPhillips (NYSE: COP), Devon Energy (NYSE: DVN), EOG Resources (NYSE: EOG) and Occidental Petroleum. The research firm has four-star ratings on each of those stocks.

“The names we favor on this yardstick, within this subset, are those with cash from operations of at least 100% of capital spending; the names we view as more risky are at less than 75%. Essentially, both categories are roughly equal distances removed from the peer median of 87% that we see today,” said S&P.