The 3 Best ETFs to Bet On

Shale oil explorers and producers are among the most volatile companies in the energy sector. When these companies are wrapped in exchange-traded funds (ETFs), investors can choose between strategies involving indirect participation, hedged portfolios and direct exposure with high levels of volatility. Three ETFs particularly stand out for using these strategies, should the shale industry rebound, as of March 10, 2016.

The SPDR S&P Oil & Gas Equipment & Services ETF

Should a recovery in the U.S. shale oil industry occur, the companies that compose the holdings of the SPDR S&P Oil & Gas Equipment & Services ETF (NYSE ARCA: XES) should benefit as well. Unlike conventional drilling with rigs that can pump relatively consistent levels of oil for 20 years or more, a typical shale oil well loses about 70% of production in the first year. By the third year, production is reduced to a trickle. The need to replace lost production puts shale oil companies in a constant state of drilling new wells, but with oil's price in the mid-$30s and the break-even price on shale oil being around $50 per barrel, oil producers have slowed the development of new wells.

However, an increase in oil prices to the point where shale oil can be extracted and produced at a profit would likely start a new round of rig construction as companies play catch-up to replace lost production and rebuild their balance sheets. The SPDR S&P Oil & Gas Equipment & Services ETF could also benefit from lower shale oil production costs due to improvements in technology. On average, production costs for shale oil dropped from $100 in 2006 to $50 per barrel by the end of 2015 as advances in fracking technology resulted in lower up-front costs and more output per well. The continuation of this trend would lower the break-even point for production costs, resulting in profitable drilling at oil prices lower than $50 per barrel.

The Invesco S&P SmallCap Energy ETF

The ETF that provides the closest thing to a pure play on shale oil companies is the Invesco S&P SmallCap Energy ETF (NASDAQ: PSCE), which focuses on exploration, production, services and equipment companies in the Standard & Poor’s Small-Cap 600 Index. The fund's largest holding at a 13.8% allocation is PDC Energy Inc. (NASDAQ: PDCE), which has shale oil operations in the Wattenberg Field in Colorado and the Utica Field in Ohio. The second-largest position in the fund is Carrizo Oil & Gas Inc. (NASDAQ: CRZO) at a 10.01% allocation, which focuses primarily on shale oil operations in Texas, Ohio, Colorado and Pennsylvania.

The portfolio’s exposure to small-cap energy companies in general, as well as shale oil explorers and producers specifically, results in a high-volatility ETF that is not for the faint of heart. For example, the fund's beta is 1.7, meaning it is 70% more volatile than the general market. However, this fund is worthy of consideration for risk-tolerant investors seeking a bet on a U.S. shale industry rebound.

The Market Vectors Unconventional Oil & Gas ETF

As a market-weighted fund, the Market Vectors Unconventional Oil & Gas ETF (NYSE ARCA: FRAK) concentrates 58.48% of its top 10 holdings in large-cap companies that get a small percentage of revenues from shale oil, and distribute the balance of its holdings over smaller exploration and production companies. For example, the fund’s largest holding is Occidental Petroleum Corp. (NYSE: OXY), which operates in three distinct segments: oil and gas, chemicals, and midstream and marketing. The company announced in October 2015 that it was reducing its exposure to shale oil by selling its operations in the Bakken field, located in North Dakota. These operations represented Occidental's largest stake in shale oil.

As a result of its concentrated holdings of large-cap integrated oil positions mixed with small-caps in the oil and gas sector, the ETF offers hedged exposure to shale oil companies, with relatively lower volatility than a portfolio composed entirely of small-cap explorers and producers. For example, its return over 2015 was -34.01%, versus the Invesco S&P SmallCap Energy ETF’s loss of 48.3% during the same period. The performance relationship of these funds is similar on the upside, as the one-month return for the Market Vectors Unconventional Oil & Gas ETF was 17.48%, while the Invesco S&P SmallCap Energy ETF gained 24.41% over the same period.

The Bottom Line

These ETFs provide investors with three strategies to bet on a rebound for the U.S. shale industry. As an indirect play, the SPDR S&P Oil & Gas Equipment & Services ETF will benefit as producers expand their drilling operations. The Market Vectors Unconventional Oil & Gas ETF offers hedged exposure with relatively less volatility. For risk-tolerant investors, the direct and high volatility exposure provided by the Invesco S&P SmallCap Energy ETF will likely deliver the biggest price swings out of these three ETFs, both on the upside and the downside.