Pump Or Dump? Understanding The Potential Of FILL ETF In An Unpredictable Oil Market

The iShares MSCI Global Energy Producers ETF (NYSEARCA:FILL) has an interesting investment approach. Oil producers take up the lion's share of its portfolio. Unlike some of its competitors, FILL doesn't just stick to the home turf. It's got a strong representation from international oil powerhouses, including the big players from Europe. If oil prices start to tick upwards, FILL is in a great spot to ride that wave. However, I do have some reservations with the unpredictable future of oil, hence my preference to stay on the sidelines for now. But many of the top-tier oil companies, who feature prominently in FILL's holdings, are undergoing strategic shifts. And this could potentially bode well for FILL's performance, which is why this ETF is worth following.

Introduction

iShares MSCI Global Energy Producers ETF aims to give investors exposure to companies around the world that are involved in the production of energy commodities, such as oil, gas, refined petroleum products, and coal mining. In contrast to other prominent energy sector funds like Vanguard Energy ETF (VDE), Energy Select Sector SPDR Fund (XLE), and Fidelity MSCI Energy Index ETF (FENY), which mainly focus on US-based energy producers, this ETF also considers those international companies that make significant contributors to the global energy market. It includes companies from developed regions like European oil giants Shell (SHEL) and TotalEnergies SE (TTE), as well as emerging markets like Reliance Industries from India and Saudi Arabia's oil titan Saudi Aramco (ARMCO) — companies that many leading energy ETFs often overlook.

With $107 million in assets under management and 222 companies in its portfolio, FILL has a balanced global reach. It invests about 53% of its holdings in US-based firms, while most of the rest span across Europe, India, Australia, China, and Brazil. Dominated by US and European energy firms, these constitute slightly over 70% of the ETF. Nevertheless, FILL encompasses nearly all the top oil, gas, and refined petroleum product firms from developed and developing nations, including Canada's Suncor Energy (SU), China's PetroChina (OTCPK:PCCYF), Brazil's Petrobras (PBR), Japan's Inpex Corp (OTCPK:IPXHY), and Hungary's MOL Group.

In essence, if there's a key oil and gas firm from either developed or emerging markets, it's likely a part of FILL's portfolio (with the notable absence of Russian energy companies). Offering broader diversity in terms of the number of holdings and geographic exposure than many of its counterparts like VDE and XLE—which primarily consist of about 120 US-based energy firms— I think FILL is an excellent choice for investors seeking to diversify their portfolios and gain exposure to some of the largest energy companies outside the US.

The Oil Connection

FILL, as the name suggests, is dominated by companies who get a large chunk of their revenues from oil sales. The vertically integrated oil companies like Exxon Mobil (XOM) and Shell account for 56.8% of the ETF while the independent exploration and production companies like ConocoPhillips (COP) and EOG Resources (EOG) account for 28.8% of the ETF. Meaning that together, these two industries whose earnings are generated primarily from oil sales, represent almost 86% of FILL.

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In the previous year, FILL's leading holdings benefited greatly from elevated oil prices, which significantly boosted their earnings. For example, Exxon Mobil, which alone constitutes nearly 17% of the ETF, reported a staggering 156.8% rise in adjusted earnings to $59.1 billion, generating $62.1 billion in free cash flows. This dramatic profit increase largely stemmed from the robust performance of Exxon Mobil's upstream business, which saw adjusted profits skyrocket by 141.6% to $39.4 billion. The uplift was primarily due to higher oil prices, with WTI averaging $94.90 a barrel in 2022, up from $68.13 in 2021—despite the company's production levels remaining relatively stable at 3.7 million bpd.

Similarly, other holdings within FILL, including Chevron, Shell, TotalEnergies, and ConocoPhillips, reported substantial earnings growth, more than doubling their profits driven by the rise in commodity prices. This positive trend significantly impacted FILL's performance, resulting in robust returns of 42.5% for its shareholders in 2022.

Indeed, FILL's performance is tightly linked with oil prices—a connection that proved favorable in 2022, propelling the ETF higher. However, this relationship has turned detrimental in the current year. With falling oil prices, the ETF has also faced downward pressure, experiencing a 4% drop in value so far. Despite closely tracking oil price movements, FILL managed to deliver better returns than the commodity itself, as WTI and Brent crude have both seen reductions of about 13% to 16% this year.

Oil Price Outlook

The year 2023 has thus far proven challenging for oil prices, with supply and demand dynamics keeping prices subdued—WTI has predominantly fluctuated within the $70 to $80 per barrel range. In the year's first five months, the WTI spot price averaged $75.85 a barrel, markedly lower than the near $99 per barrel seen during the same period last year.

On the supply side, OPEC+, which accounts for 40% of global crude oil supplies, has been reducing production to bolster oil prices. The group's output hit a 19-month low in May following significant production cuts by Saudi Arabia, Iraq, the UAE, among others, with Russia also reducing output. Earlier this month, Saudi Arabia, OPEC+'s driving force, announced plans to decrease its output substantially by 10%, or one million barrels per day, in July, and maintain lower production levels in the future if necessary. Many other OPEC+ members have concurred to continue with the reduced oil production levels agreed upon in April through 2024. Consequently, I believe it's reasonable to expect that OPEC+'s supplies will remain restricted in the future, posing a downside risk.

Contrastingly, I think the demand side presents a more ambiguous picture. We have the economic slowdowns in the developed world negatively affecting demand. For instance, US GDP growth fell sharply from an annualized rate of 2.6% in Q4 2022 to 1.1% in Q1 2023. Although the Federal Reserve's decision to pause interest rate hikes could spur economic growth and push oil prices up, the central bank has also hinted at further hikes in 2023 due to high inflation, counteracting oil's potential gains. Meanwhile, the Eurozone entered a technical recession in Q1 2023, largely due to weak domestic demand. I believe the inflationary pressures and interest rate hikes by the central bank could continue to burden the 20-nation bloc, affecting oil prices.

Then there is China, the leading emerging market and oil importer whose economy was widely expected to bounce back this year after it lifted COVID-19 lockdowns and travel restrictions. The surge in demand was expected to lift oil prices. But China’s recovery, especially in the current quarter, has been rather lackluster. But the Chinese central bank's recent decision to reduce short-term lending rates could boost GDP growth and support oil prices.

Taking into account the Federal Reserve's pause, China's stimulus measures, and Saudi Arabia's oil cut, I believe these could shore up oil prices, potentially from the second half of the year, if we start seeing the effects of these measures and decrease in crude oil inventories. However, the gains might be limited due to sluggish economic growth worldwide. Given the uncertain economic trajectories of the US and China, the future oil demand remains unclear. In this context, oil prices might continue to fluctuate between $70 and $80 per barrel.

Impact on FILL

As previously indicated, FILL's performance is closely linked to oil price movements. The prospect of a short-term recovery in oil from the current level of approximately $70 a barrel enhances the outlook for FILL's underlying holdings, potentially triggering a rally in this ETF.

In addition to oil prices, I believe it's vital to closely monitor how some of the most substantial oil producers, all top holdings of FILL, are adapting to the current oil price environment. Remember, WTI averaged around $88 a barrel in the latter half of the previous year. If this commodity continues to range between $70 and $80 a barrel for the remainder of 2023, as observed in H1 2023, oil companies may not garner any support from oil prices. Their realized oil prices in H2 2023 could be lower than those in H2 2022, which could negatively impact their YoY earnings.

However, this negative effect might be mitigated by some major oil producers' renewed emphasis on profit growth and enhancing shareholder returns. Despite realizing lower oil prices in Q1 2023, some producers managed to increase profits due to higher production volumes. The prime example is Exxon Mobil, FILL's largest holding, which reported record-breaking Q1 profits of $11.4 billion, up from $5.5 billion the previous year. Excluding the impact of one-off items, the company's profit increased by 31.5% YoY to $11.6 billion, with the adverse effect of lower prices being offset by a 300,000 boepd increase in production.

In my view, this may reflect a broader strategic shift occurring within the energy industry. Earlier this year, Bernard Looney, CEO of BP (FILL's sixth-largest holding), unveiled plans to escalate E&P operations, marking a significant shift for a company that declared in 2020 it would largely cease searching for new oil and gas reserves. While BP still plans to reduce overall production by 25% by 2030, this represents a significant downgrade from its initial aim of a 40% reduction in the long term. BP intends to maintain core production from high-yield oil and gas fields and dispose of unattractive mature assets, leading to lower production but potentially higher returns.

Similarly, Shell announced a strategic shift, intending to keep oil production flat until 2030 while boosting natural gas output to consolidate its status as a global leader in the LNG sector. The company also plans to increase shareholder returns, allocating approximately 35% of its cash flows to shareholders, up from its initial plan of around 25%.

These oil producers are demonstrating a willingness to capitalize on their strengths by amplifying investments in their core oil and gas operations, rather than renewable investments that may not yield as much returns. This approach could positively affect their bottom line, boost their shares, and consequently impact FILL positively.

Takeaway

FILL, being an oil heavy ETF, closely follows oil prices. A rally in the ETF might occur if oil prices see a gradual recovery spurred by an uptick in demand as the Federal Reserve eases off and China's central bank reduces interest rates amid dwindling supplies from OPEC+. However, the future of oil remains uncertain, with ambiguity persisting around future demand levels. If, for instance, stimulus measures implemented by China fail to revitalize oil demand, prices may remain subdued, potentially negatively affecting FILL's performance.

The outlook for oil is shrouded in considerable uncertainty, which is why I recommend that investors remain cautious for now. However, it's reassuring to note that the largest holdings within FILL are implementing measures to enhance their performance and yield robust returns for shareholders. This could positively influence their share performance and, in turn, benefit FILL. Due to this potential positive impact, I anticipate that FILL might outperform oil prices.

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