PXE: Oil And Gas ETF With Tailwinds

Invesco Energy Exploration & Production ETF (NYSEARCA:PXE) is a passively managed exchange-traded fund. The fund tracks the Dynamic Energy Exploration & Production Intellidex Index. The fund provides exposure to oil and natural gas companies that explore, extract, and refine these resources, creating gasoline, liquid natural gas and other finished products. This fund is allocated to U.S. equity companies across the market cap spectrum, with over half the assets invested in small and micro-cap firms. We like this given the high rate of M&A activity currently in the oil and gas market. When comparing PHE to its peers, the fund looks favorably and competitive on a variety of metrics including expected multiple expansion, return on equity and expected earnings growth.

The oil and gas industry faces many competing priorities. During the pandemic, demand plunged due to lockdown policies, and coming out of the pandemic, oil prices surged due to increasing demand, and supply restrictions. Demand recovered to pre-pandemic levels in 2023 and is expected to continue to grow despite a worldwide push toward a low-carbon and eventually net-zero future. This spike in oil prices highlighted the importance of the commodity and the fact that the world has a long way to go before it can be phased out.

Firms need to balance the priority of investing in renewable energy technologies to remain relevant long-term, while also continuing to produce an adequate supply of traditional energy in the short to medium term. We think that PXE’s allocation to firms across the market cap spectrum could work well in this environment, as larger firms have increasingly looked to mergers and acquisitions to secure increases in their production capacity. A historic amount of consolidation took place in the industry in 2023, with $144 billion in M&A activity in the fourth quarter, and $190 billion for the year. Both of these figures were record setting.

Holdings

Below are the top 10 holdings for PXE.

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Phillips 66 (PSX) is one example of a firm we can look at that is continuing to invest in its legacy oil and gas business, while also moving to diversify into more renewable segments. In its 2024 Capital Program announcement, the firm stated that it plans to invest $1.1 billion in refining, including $412 million in maintenance CAPEX, and $654 million in growth CAPEX. This growth CAPEX includes finishing the conversion of a traditional refinery in San Francisco into a plant producing multiple types of renewable fuel. The plant will be capable of producing renewable diesel at a rate of 50000 b/d (barrels per day) as well as sustainable aviation fuel and renewable jet fuel at 20000 b/d and 10000 b/d, respectively. When all is said and done, it is estimated that the project will cost the firm $1.25 billion. The CEO of the firm, Mark Lashier, recognized that the earnings of the converted plant would “far exceed” the previous one.

Below is a map of renewable diesel projects across the U.S.

The firm is also engaging in acquisitions. Last year, the firm completed its purchase of DCP Midstream, allowing the firm to now participate in the entirety of the natural gas liquids (NGL) supply chain. The firm stated that it expected $400 million in synergies to be unlocked due to the acquisition by 2025. This is an example of how firms are creating a diversity of business segments for the future, pursuing growth from both renewable and traditional energy sources.

Comparing ETFs

The table below compares PXE to two other funds in the space: SPDR S&P Oil & Gas Exploration & Production ETF (XOP) and iShares U.S. Oil & Gas Exploration & Production ETF (IEO).

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A few things stick out. First off, PXE is significantly more concentrated. We prefer this as it is easier to understand what you own with fewer names, and 30 stocks still allow for solid diversification. PXE is also the cheapest fund based on weighted average PE Ratio, and this multiple is expected to double according to YCharts forecasts. This outsized multiple expansion compared to XOP and IEO is another reason we favor the fund. The 5-year earnings growth forecast is competitive with the other funds, as well as the expected dividend yield. With yields in the mid-5% range, that is another reason to like this space, especially when you can get that income on a quarterly basis. As previously stated, we also like the lower weighted average market cap of the firm, as smaller firms could benefit from the rate of M&A transactions.

Risks of Investing in Oil and Gas

The primary risk of oil and gas investing is that a firm’s revenues can fluctuate largely with the prices of the commodities it produces, and those price movements are difficult to predict. Using derivatives contracts to hedge a decline in prices is a way to mitigate this. Also, natural disaster risk could affect these firms as they must extract materials from the earth, and equipment can be significantly damaged and operations slowed if a disaster occurs.

Conclusion

We believe firms that balance the need for investments in renewable energy while continuing to maintain and grow their operations in traditional energy will be the most successful. This is exemplified by PXE’s top holding, Phillips 66. The high rate of M&A in the oil and gas industry is favorable for PXE’s portfolio in our view, as it contains a significant allocation to smaller firms that could be beneficiaries. The fund also ranks favorably versus peers on a number of important metrics. We rate PXE a buy.