iShares U.S. Energy ETF (IYE): An ETF Inflation Or Oil Price Play

(This article was co-produced with Hoya Capital Real Estate)

Introduction

A question everyone wants to know is, “Are we entering another decade of high inflation, or is the recent spike caused by monetary decisions and supply-chain issues?”.

I think most economists would agree that the next chart helps to explain why inflation averaged near 9% for the 1973-1982 decade.

The benchmark OPEC price went from under $2/barrel in 1972 to over $35/barrel in 1982. Naturally oil stock profits soared during this time. If oil prices drove inflation, it could lead investors to wonder how much that influenced the results of presented in the next chart.

The next chart that shows Energy stocks perform very well during periods of above-average inflation, such what we are in now, only lagging Value stocks.

Exploring the iShares U.S. Energy ETF (NYSEARCA:IYE)

Seeking Alpha describes this ETF as:

The fund is managed by BlackRock Fund Advisors. It invests in public equity markets of the United States. It invests in stocks of companies operating across energy sectors. It invests in growth and value stocks of companies across diversified market capitalization. The fund seeks to track the performance of the Russell 1000 Energy RIC 22.5/45 Capped Index. IYE started in 2000.

Source: seekingalpha.com IYE

IYE has $2.9b in assets and provides investors with a 2.5% yield. iShares charges 41bps in fees, which in this writer’s opinion in today’s ETF world, is too much.

Understanding the Index used

BlackRock, the manager of iShares ETFs, moved 10 ETFs from Dow Jones indices to FTSE Russell in September 2021. Before that, IYE invested based on the Dow Jones US Oil & Gas Index. FTSE Russell describes their Index as:

The Russell 1000 Energy RIC 22.5/45 Capped Index measures the performance of US large cap companies that are assigned to the Energy Industry by the ICB sector classification framework. At the quarterly index reviews, all companies that have a weight greater than 4.5% in aggregate are no more than 45% of the index, and no individual company in the index has a weight greater than 22.5% of the index.

Source: research.ftserussell.com Index

The “capping” rules are applied quarterly and FTSE Russell has a complete document explaining the detailed capping process. These statistics were provided:

The stocks have to be included in the Russell 1000 Index to be considered by this Index. The Russell 1000 Index measures the performance of the large-cap segment of the US equity universe. It is a subset of the Russell 3000 Index and includes approximately 1,000 of the largest securities based on a combination of their market cap and current index membership. FTSE Russell uses their Industry Classification Benchmark to classify companies, not the more widely known GICS coding, though they are very similar. Reconstitution of all FTSE Russell indices occurs on the fourth Friday in June.

IYE ETF characteristics

Note the 3-Yr StdDev. At over 41%, this ETF is not for those looking for stable investments. The volatility is also reflected in the 1.72 beta, meaning this ETF move 72% more than the S&P 500, in this case. Fidelity offers an expanded list of portfolio factors.

To really appreciate the above table, you need to see how these values compare to the past, which I was not able to locate despite checking out my usual investment sites. That said, here are three for the top three holdings, which are reviewed next.

The PS ratio chart is Price-to-Sales. The third, Enterprise Value, or EV, has considered the theoretical purchase (“takeover”) price of a business because a purchaser would take on the company’s debt, while pocketing the company’s cash and gaining a right to all of the company’s future earnings. I will leave it to the readers to also decipher the charts, as they seem to provide a mixed picture as to whether these companies are over or under-valued compared to ten years ago.

Holdings review

The Energy industry consists of several sub-sectors and IYE has exposure to each, accounting for 96% of the asset value of the ETF.

Top Holdings

With 38% of the ETF in two stocks, which are basically the same, they will have an oversized impact on the performance of this ETF.

These are the indirect energy companies owned as of 2/24/22. Both stocks classified as Information Technology are primarily in the solar energy segment of the energy industry and design and install solar panels.

Distribution review

Except for the large 2019 year-end payout, distributions have not grown over the last ten years. This is reflected in Seeking Alpha’s dividend scorecard.

The low yield means IYE is not for investors focused on income either.

Portfolio Strategy

To be fair, since I included the above chart from Dimension Fund Advisors, is to include this one too.

DFA’s research showed that for Energy stocks and commodities over 1991–2020, the correlations versus inflation are reliable, but the assets’ nominal returns have been around 20 times as volatile as inflation, and more than half of their nominal-return variation has been unrelated to inflation. The above chart illustrates this by showing how the annual nominal returns to energy stocks and commodities differ dramatically from the annual realizations of inflation.

A better predictor for IYE

Based on the above chart, energy stocks, thus the IYE ETF, appear to correlate better with the WTI price than YOY inflation. If so, the trends for both oil prices and Energy stocks look positive, especially if energy sanctions are placed on Russia.

Possible energy sanction effects

As of now, the only major energy industry sanction imposed on Russia for invading the Ukraine is Germany’s freeze on the Nord Stream 2 pipeline that would have added to Russia ability to supply Western Europe with natural gas. The EU and the USA imposed restrictions and controls on defined oil and gas activities in Russia in 2014, and these remain in force.

Russia supplies one out of every 10 barrels of oil used around the world. While foreign companies participate, approximately 81% of Russia’s total crude oil production in 2020 came from Russian firms: Rosneft, Lukoil, Surgutneftegas, Gazprom, and Tatneft. Examining Exxon’s Annual Report, only 2% of their long-lived assets are in Russia. BP’s exposure appears limited to their 19% voting rights in Rosneft, which they just agreed to exit from. Shell, via joint venture with Gazprom, get 10% of its natural gas supply from Russia.

Opinions vary whether the EU will ever ban natural gas imports from Russia, thus imposing total energy industry sanctions. Russia is the 2nd largest natural gas producers and supplies 19% of the world demand; the EU gets 41% of their supply from Russia. Most major oil companies have some production coming from Russian oil and natural gas fields.

Another energy strategy (?)

If energy stocks are better correlated to the movement in the WTI price, investors can skip this ETF and invest in the iPath Pure Beta Crude Oil ETN (NYSEARCA:OIL), which Seeking Alpha describes as:

The investment seeks to provide investors with exposure to the Barclays WTI Crude Oil Pure Beta Total Return Index. The Barclays WTI Crude Oil Pure Beta Total Return Index (the “index”) reflects the returns that are potentially available through an unleveraged investment in the futures contracts in the Crude Oil markets. The index may roll into one of a number of futures contracts with varying expiration dates, as selected using the Barclays Pure Beta Series 2 Methodology.

Source: seekingalpha.com OIL

The risks are very different being an ETN, which is a debt instrument back only by Barclays Bank. Being that it is a series of WTI futures, it should respond faster than the IYE ETF to movements in the price of oil, but the next chart doesn’t seem to support that statement.

Final thoughts

The Energy industry is facing challenges that are more unique to it than most other sectors. All of these and others need to be evaluated by anyone investing in this sector these days.

• Climate activists recently won three Board seats at Exxon. Company energy investment plans already seem to be altered.
• Climate policies could limit companies from fully utilizing/extracting fossil fuel resources that spent billions developing.
• A growing push for foundations to divest these stocks or to block banks from funding new fossil fuel projects.
• Worldwide inflation which is being fought by rising interest rates could slow growth and the demand for fossil fuels.
• Oil almost broke $100 this week, a price not seen since 2014. Natural Gas is trading consistently over $4.50, a level last held in 2008. This could mean energy stocks already have these elevated prices built in.
• Predictions of what Putin’s end-game is a wildcard, as is the outcome in Ukraine. Both make predicting what additional sanctions will be difficult.