ERX: Be Patient With This Energy ETF (NYSEARCA:ERX)

In this article, we will review energy stocks and determine if a leveraged ETF would be one to consider by investors. The Direxion Daily Bull (NYSEARCA:ERX) seeks to return two times the daily performance of the Energy Select Sector Index.

Risks

Energy companies are inherently risky as they are dependent on the price of crude oil and actions taken by OPEC. In addition, crude oil prices are also influenced by environmental, political, and geo-political factors. If that was not enough, the refining capacity and type of crude oil that a certain refinery can refine complicates the process.

Using a leveraged fund to invest in a speculative sector adds to the risks. Leveraged funds have erosion due to beta slippage. Leveraged funds borrow money to amplify returns. In addition, losses get amplified, and due to daily rebalancing, the overall returns will impact returns to the downside. For example, on day one, if an exchange-traded fund (“ETF”) is down 10%, then a 2X leveraged fund would be down 20% and it resets. The next day, if the ETF is up 11% then it would be back to even. However, the leveraged ETF would be up 22%, but it needs to be up nearly 25% to be back to even. Over time, the down days reduce the overall return of leveraged funds.

Demand and Supply

Global crude oil demand is forecast to increase from 99.4 million barrels per day in 2022 to 102.3 million barrels per day by 2024. Global crude oil production averaged 101 million barrels per day in 2022 and is likely to increase to 102.6 million barrels per day in 2024.

Crude Oil Production

The crude oil production forecast by U.S. Energy Information Agency (‘EIA’) is an increase from 12.4 million barrels per day in 2023 to 12.8 million barrels per day in 2024. This will be an increase from 2022 of 11.9 million barrels per day and higher than the prior record of 12.3 million barrels per day in 2019. The additional barrels of oil are coming from increased production from the Permian region by 470,000 barrels per day and by 350,000 barrels per day.

The Organization of Petroleum Exporting Countries (‘OPEC’) is producing 28.83 million barrels per day of the total 101.5 million barrels per day produced in the world. OPEC production fell 744,000 barrels per day with reductions coming from Saudi Arabia, the United Arab Emirates, and Kuwait.

Crude Oil Demand

Demand for crude oil is back to its prior trend and is likely to surpass daily demand levels from 2019 to 2023.

U.S. Strategic Petroleum Reserves have fallen near 650 million barrels, down to just around 400 million barrels. If crude oil prices were to go down, then it’s likely that U.S. strategic reserve will keep a floor on the crude oil price as U.S. refills its strategic petroleum reserve.

About the Fund

The Direxion Daily Energy Bull (ERX) seeks to return two times the daily return of the performance of the Energy Select Sector Index. The funds should not expect to provide two times the return of the benchmark’s cumulative return for periods greater than a day. The leveraged instruments should be used by traders with experience using a leveraged fund, and not recommended for the long term investor.

Fund Holdings

The main holdings of the fund are primarily the major domestic energy stocks in the energy select sector. The domestic companies include the following industries: oil, gas, consumable fuels, energy equipment and energy services. The ERX is dominated by the two giant energy companies, Exxon and Chevron Texaco, with about 43% of the fund.

Dividends

The fund pays out a dividend of 2.3%.

Fund Expenses

The fund is expensive like other leveraged funds and charges annual fees of 0.95%, which are much higher than average.

Quant Ranking

ERX is ranked highly overall and within its asset class as well as sub class.

Chart

The chart of XLE is consolidating after a big move up from October 2021 to May 2022. From a technical analysis perspective, XLE needs to stay above $80 to remain in an uptrend. However, for the conservative investors, it is best to wait until XLE closes above 95 before buying ERX. Right now, XLE is consolidating and any down move in XLE would be magnified in ERX.

West Texas crude oil topped in April 2022 and has dropped from just below $120 per barrel to around $77 per barrel. Crude oil needs to hold $70 per barrel, or else crude oil would go into a downtrend and energy sector stocks are likely to go down.

Comparison XLE to Crude Oil

Crude oil outperformed XLE from September 2021, but since mid-2022 XLE has outperformed crude oil. So far, investors have been comfortable holding equity as long as the crude oil does not fall below $70 per barrel.

Longer-Term View

Both XLE and crude oil have run into resistance at levels going back to 2008. I would expect pullback in XLE as well as ERX as crude oil has pulled back and both are highly correlated over longer period of time.

Valuation

Exxon

Revenue and earnings for Exxon are forecasted to go down in the coming quarters. Price to earnings and gross profit margins, among other valuation measures, are attractive. Dividends are attractive for Exxon at 3.18%, and with a low payout ratio, they would be considered very safe. Dividend growth has been slow in the past 5 years.

Chevron Texaco

Revenue and earnings for Chevron Texaco are forecasted to go down in the coming quarters. Price to earnings and gross profit margins, among other valuation measures, are attractive. An attractive dividend yield of 3.59% and a low payout ratio makes the dividend very safe. The dividend has gone up on a slow and steady pace.

Schlumberger

Revenue and earnings for Schlumberger are forecasted to go higher in the coming quarters. Price to earnings and gross profit margins, among other valuation measures, are attractive. Dividend yield is at 1.86% and a low payout ratio does make the dividend relatively safe. Dividends were cut as their services were affected when crude oil prices fell.

ConocoPhillips

Revenue and earnings for ConocoPhillips (COP) are forecasted to go down in the coming quarters. Price to earnings and gross profit margins, among other valuation measures, are attractive. Dividend at 1.86 is safe due to a relatively low payout ratio. Steady increase in dividend over the past five years.

EOG Resources

Revenue and earnings for EOG Resources are forecasted to go down in the coming quarters. Price to earnings and gross profit margins, among other valuation measures, are attractive. Attractive dividend of 2.6%, which is very safe due to a really low payout ratio. Dividend has seen a fairly decent growth over the past 5 years.

The largest holdings are reasonably valued compared to the overall stock market. Revenue growth for Exxon, Chevron Texaco, and ConocoPhillips is expected to slow in the 2023. Unless crude oil starts to move up, it would be reasonable to expect a pullback in energy stocks.

FINRA on Leveraged ETFs

Leveraged ETFs should be avoided unless a sophisticated trader uses them for day trading or a short time-frame with strict risk management. FINRA warning:

“Exchange-traded funds (‘ETFs’) that offer leverage or that are designed to perform inversely to the index or benchmark they track-or both-are growing in number and popularity. While such products may be useful in some sophisticated trading strategies, they are highly complex financial instruments that are typically designed to achieve their stated objectives on a daily basis. Due to the effects of compounding, their performance over longer periods of time can differ significantly from their stated daily objective. Therefore, inverse and leveraged ETFs that are reset daily typically are unsuitable for retail investors who plan to hold them for longer than one trading session, particularly in volatile markets.”

Summary

For an equity investor, energy stocks can be challenging to invest due to their correlation with crude oil. Economic slowdown across the world would be a headwind for crude oil, though refilling the strategic petroleum reserve will be a support. However, valuations are reasonable and management is returning cash in the form of dividends. The projected revenue and earnings for some of the energy sector companies is projected to slow in the coming quarters. Slowing revenue and earnings is a headwind for investors in 2023. A better way to invest in the energy sector would be by picking individual stocks rather than a leveraged ETF. My personal recommendation would be to be patient and use ERX primarily as a trading vehicle.