Jeff Gundlach's new energy-sector trade has potential to be a gusher

  • Jeff Gundlach told the Sohn Investment Conference on he is long the SPDR S&P Oil & Gas Exploration & Production ETF (XOP).
  • XOP has trailed another big oil and gas ETF, the iShares Dow Jones US Oil and Gas Exploration and Production (IEO), by a wide margin this year.
  • But XOP could have more room to run because of its focus on smaller market cap energy stocks.

Investor Jeff Gundlach may be best known for his bond bets, but he has been talking about commodities as one of the market's best trades since the beginning of the year.

On Monday he revealed a specific trade for what he sees as an underappreciated opportunity in the energy sector.

Speaking at the Sohn Investment Conference, where many managers disclose their latest investment ideas, the founder and CEO of DoubleLine Capital said he bought shares of the SPDR S&P Oil & Gas Exploration & Production ETF (XOP) because he thinks energy stocks have not yet received the full benefit of the crude-oil rally.

"It's lagged in a way that's kind of bizarre this year," Gundlach told CNBC on the sidelines of the conference. "It's not a very great performing sector, and yet oil has gone up towards $70 a barrel."

Gundlach continued: "If you look historically at the energy sector versus the S&P 500, not surprisingly it's correlated with movements in oil. That hasn't happened this time, and I think there's a catch-up there. The charts look good on XOP, the exploration and production part of the sector."

The chart is arguably better for XOP than some other broad energy ETFs. The iShares Dow Jones US Oil and Gas Exploration and Production (IEO) is up 21 percent in the past year, versus only 11 percent for XOP. WTI crude oil is up by about 25 percent in the past year. So far in 2018, IEO is up more than 8 percent — best among U.S. energy sector ETF bets — while XOP is up a little under 5 percent. That performance gap may represent where there is more money left to be made in oil and gas companies.

ExxonMobil oil rig
Source: ExxonMobil
ExxonMobil oil rig

"XOP has the spicy meatball names that are highly levered and went down a lot more from peak to trough on 'going' concerns," said Kim Arthur, founding partner at Main Management, an asset manager that uses ETFs extensively in its portfolio construction.

There is an important difference in the underlying indexes: IEO is market-cap weighted; XOP is equal weighted. That means XOP holds many smaller-cap energy companies and holds them at roughly equal percentages, while IEO is weighted to larger market capitalization companies.

"This is why what's inside an ETF and not just its name and expense ratio are important," said Todd Rosenbluth, director of ETF and mutual fund research at CFRA. "XOP is equally weighted and has more small and mid-cap exposure than IEO so it will be down more in down years for the energy sector."

That also means it could go up more, if the energy sector and crude oil continue to rise.

"Bigger, disciplined, shareholder-friendly oil companies are good for long-term focused investors but smaller players have more leverage to rise in oil prices," said Neena Mishra, head of ETF research at Zacks Investment Research.

IEO's 10 biggest holdings account for almost 60 percent of its assets. Its top holding, ConocoPhillips, represents 11.3 percent of the ETF, and it's up about 40 percent over the past year, versus 15 percent on average for oil and gas exploration stocks. Valero Energy is another top holding, with about 7 percent allocation. It's a refining stock that has risen about 73 percent over the past year, about 25 percent above its peer group average return. Another refiner, Marathon Petroleum, accounting for about 6 percent of IEO's holdings, is up about 69 percent over the past year.

And all three are up more than 18 percent this year. As these three stocks have significantly outperformed the broader energy industry, the market-cap-weighted IEO has done much better than the equal-weighted XOP, Mishra said.

XOP's largest holding is $3 billion market-cap QEP Resources, at a weight of roughly 2 percent. It's up 13.5 percent in the past year, though it has really started taking off, up 31 percent in the past month.

The average market cap for IEO is $20 billion; it's $7 billion for XOP.

"If oil prices continue to climb, smaller companies that have lagged so far could be good short-term plays," Mishra said.

Average market cap and recent returns in energy ETFs

ETF
Avg. Market Cap
Year-to-date return
One-year return
SPDR S&P Oil & Gas Exploration & Production $7 billion 4.72% 11.99%
iShares Oil & Gas Exploration & Production $20 billion 8.27% 21.38%
PowerShares S&P 500 Equal Weight Energy $25 billion 2.37% 6.74%
Fidelity MSCI Energy Index $53 billion 2.30% 10.71%
Vanguard Energy $54 billion 2.42% 10.96%
iShares US Energy ETF $61 billion 2.21% 10.82%
Morningstar

Small- and mid-cap energy stocks comprise more than 70 percent of XOP, versus roughly 40 percent of IEO's holdings.

Gundlach himself presented the biggest risk to the energy stock thesis tilted to higher-levered exploration and production companies, though it's a risk that does apply to all energy stocks: "The only problem with that idea, I think, is maybe we go into a recession. … Once the recession comes, it is almost certain to go down."

And XOP is almost certain to go down more than IEO. Over the past five years, IEO has returned 2 percent on an annualized basis, while XOP has returned –5.7 percent.

"XOP has a lower expense ratio [0.35 percent vs. 0.44 percent], but IEO is a strong candidate for investors wanting exploration and production exposure. But IEO outperformance in the past year should only mean so much," Rosenbluth said.