ETF Prime: Stacey Morris Drills Into Past & Future of Energy

On the recent ETF Prime, host Nate Geraci is joined by VettaFi’s Stacey Morris to examine the energy ETF category and discuss key performance drivers moving the future of energy forward. F/m Investments’ Alex Morris went in-depth on the recently launched U.S. Benchmark Series, which allows investors to own each of the “benchmark” U.S. Treasuries in a single-security ETF. For the final segment, Constrained Capital’s Mark Neuman spotlighted the Constrained Capital ESG Orphans ETF (ORFN).

Getting Energy Exposure

Energy is the top-performing sector in a challenging year. In the ETF Space, Geraci noted that there are about 60 energy ETFs out there, led by the Energy Select Sector SPDR Fund (XLE). Of course, there are many ways for investors to get exposure to energy.

“The way I would divide this sector is by looking at how these companies make money and how they are organized into different subsectors from an ETF perspective,” Morris said, noting that investors who are bullish on commodity prices and energy in the future can look at something like the SPDR S&P Oil & Gas Exploration & Production ETF (XOP) which owns companies that produce oil and natural gas. VanEck Oil Services ETF (OIH) meanwhile, focuses more on service companies that support the fossil fuel industry. Income-hungry investors might want to consider the midstream and MLPs through funds like the Alerian MLP ETF (AMLP). Morris also noted that you can even make a natural gas-specific play through First Trust Natural Gas ETF (FCG).

Geraci wondered about how to categorize the more pure-play ETFs like the United States Oil Fund LP (USO) and if they belong in a different bucket than the equity ETFs.

“I would argue those are commodity ETFs and they come with their own nuances and risks,” Morris replied. She continued, “the use case for those is going to be different than the use case for energy equities.”

The Question of International Exposure

Morris noted that there are some complications when you start categorizing by U.S. or international exposure. “Exxon has assets in Russia, for example,” she noted. According to Morris, “it can be really hard to avoid international exposure if that’s what you are trying to do, but one way you could actually do that and get energy exposure is to own the midstream space.” Almost all MLP assets are in the U.S., making them a useful way for investors concerned about geopolitical risk to tap into the energy markets.

Investors that are looking for more international exposure in energy can look at the iShares MSCI Global Energy Producers ETF (FILL). Though Morris noted that FILL has a pretty wide net, not just capturing oil but also coal producers. Echoing VettaFi’s Todd Rosenbluth, Morris encouraged investors to “look under the hood.”

Current Energy Markets

Geraci noted that XLE has outperformed the tech and communication services SPDR by over 80%. Energy has clearly been the dominant player in a troubled market space. “My guess is that many investors attribute that to the Russia-Ukraine war,” Geraci said, asking Morris if there was more to it than that.

“Keep in mind energy was also the best performing sector last year,” said Morris, noting that even when oil hit pre-invasion price levels in September, energy stocks held up well. June through October saw price declines, but performance remained robust. Morris thinks some of this is due to the sector having been in a slumber for quite some time before its more recent breakout performance.

Morris also said, “Energy does well in periods of high inflation,” as it is arguably less sensitive to rising interest rates. One overlooked factor of energy’s recent boom, according to Morris, are the management teams who are delivering free cash flow and have done a tremendous job righting the energy ship. “I think the space has really taken its medicine, learned its lesson, and is much more investible now. Companies are executing and delivering and that deserves some credit too.”

Between 2011 and 2021, the S&P was up 360% while XLE was up a mere 14%, making the recent reversals even more potent. Several factors lead to energy’s rough decade, including overproduction having a dragging effect on oil prices. “We got into this period of very low prices for oil, ultimately bottoming at $26 per barrel in 2016,” Morris said.

During these times, energy companies were continuing to grow and expand, demonstrating that though they were good at producing energy they weren’t being effective stewards of capital, which in turn had investors put the sector “in the penalty box.” By 2020, energy was just 2% of the S&P 500. Back in 2008, it had been 16%. Morris sees the sector as becoming a lot more responsible and learning the right lessons – not growing for growth’s sake and returning capital to investors. “You can’t afford to ignore this space anymore,” said Morris.

The Future of Energy

Looking at what’s to come for the future of energy, Morris observed, “OPEC plus is clearly willing to defend a floor around $90 for oil price.” She sees commodity prices as potentially being volatile, particularly oil, but having a floor could very much continue to buoy the energy sector fin the future. Morris continued, “As we get into winter, I think there’s an upside bias in prices.”

Supply and demand remain huge factors in energy for the future, with Chinese demand expected to drop while supply constraints are likely, given the geopolitical situation. Morris noted, “a rebound in Chinese demand, for example, could be one thing that could help tighten that demand even if we see a recession weighing on demand globally.”

Morris pointed to midstream companies as the likely winners in the event of a widespread global recession. Because midstream and energy companies make money off of fees, they are less prone to being affected by commodity prices, setting up a positive future for these energy companies.

Finding the Benchmark

While the ETF universe was abuzz about single stock ETFs, F/m Investments launched single bond ETFs for their U.S. Benchmark series. With over $200 million in assets, there are more of these funds on the horizon. Alex Morris (no relation to Stacey Morris) joined Geraci for the second section to discuss these unique products.

“We had clients, advisors, friends, all asking us if, in 2022, markets reverse where do we go? The answer historically has been the U.S. Treasury market. Negative correlation to U.S. equities but positive yield,” Morris noted.

Navigating bonds can be a headache for many investors, and treasuries have their complexities on top of that. As Geraci notes, the TreasuryDirect website is far from intuitive. F/m’s Benchmark series is branded as “equitizing the yield curve.”

“We do the boring thing of just buying the cash bonds and focusing on high-quality execution and high-quality rolls,” Morris said. F/m purchases bonds “on the run” which refers to the most recently issued treasury security that corresponds to the stated tenor.

“They are quite different than single stock ETFs,” Morris said, noting that single stock ETFs have many fees and complexities of their own, whereas their products are purchased at scale, giving them superlative pricing and affordable expenses. Their three funds are the US Treasury 10 Year Note ETF (UTEN), the US Treasury 2 Year Note ETF (UTWO), and the US Treasury 3 Month Bill ETF (TBIL).

The ESG Orphanage

ORFN launched in May to focus on stocks that have been discarded by ESG, including tobacco stocks. Neuman, after reading a few research papers that posited that ESG investing will always perform less well than the securities it disposes of, decided to create a product for those “orphaned” securities.

“Everything has a cost. Consider organic food versus regular food. Organic just costs more and you’re never going to find organic food at a lower price than regular food,” Neuman said. “One of the struggles I have is the false promise that big institutions are making to be virtuous.”

ORFN is built off of companies with exposure to fossil fuel, nuclear energy, weapons, alcohol, tobacco, and gambling. Neuman noted that he chose the biggest names in each sector.

Listen to the entire episode of ETF Prime with Stacey Morris:

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