Holdings in equity-based energy exchange traded funds, including the Energy Select Sector SPDR (NYSEArca: XLE) and the SPDR S&P Oil & Gas Exploration & Production ETF (NYSEArca: XOP), have been voracious cost-cutters this year. If oil prices keep retreating, investors can expect more of the same in 2016.
There are reasons for investors to be cautious with volatile energy ETFs. Moreover, if oil prices falls to new lows and the shale industry is unable to turn a profit, the highly leveraged industry may find it harder to repay debt obligations. With the U.S. dollar strengthening and the Federal Reserve looking at tightening its monetary policy, the various U.S. market sectors and related exchange traded funds could behave differently in a strong USD environment.
“The world’s oil companies have canceled or delayed final investment decisions on ~150 projects that could wipe out 19M bbl/day from the world’s hydrocarbons and stay underground for several years longer than expected amid lower crude oil prices, according to a new report from Tudor Pickering Holt,” reports Seeking Alpha.
At issue are declining hedging positions, particularly for some of the well-known names found in exploration and production ETFs like XOP.
“That will subject them to the full savagery of oil prices flirting with 11-year lows. Without hedging, there is a much lower incentive to drill, as any barrels pulled out of the ground will be sold for much less than they would be under a hedged position,” reports OilPrice.com.
Integrated oil companies have adjusted to the low oil environment by reducing costs, divesting businesses and squeezing suppliers for better deals. For instance, BP Plc (NYSE: BP) plans to sell $3 billion to $5 billion in assets next year and divest a further $2 billion to $3 billion of assets in 2017.
This isn’t the first time the energy sector has been forced to tighten their belts. Through 1987 to 1997, companies suffered through an extended period of lower prices and responded by cutting costs, which ensured “earnings grew strongly,” according to Bernstein research.
“While the efficiency gains succeeded in bringing down costs, even some of the best shale companies are in the red at this point. Evercore ISI told The Houston Chronicle that the average breakeven cost for North American shale used to be $65 per barrel. Efficiency gains brought that threshold down to $50 per barrel. That is an impressive achievement over the course of just 12 to 18 months, but it is still higher than current prices,” adds OilPrice.com.
West Texas Intermediate futures would need to gain more than 25% from current levels to reach $50 per barrel.
SPDR S&P Oil & Gas Exploration & Production ETF
