The Time to Lever Up in Energy Is Now

05/12/2011 4:05 pm EST


Igor Greenwald

Chief Investment Strategist, MLP Profits

The recent sell-off in energy commodities and stocks presents a buying opportunity, writes MoneyShow Senior Editor Igor Greenwald.

Big Oil is guilty as sin—guilty of being so blindingly obvious.

ExxonMobil (XOM) is a $400 billion company that has earned $137 billion over the last four years. This is money most voters can see flowing from their bank accounts to the industry every time they fill up the tank, cent by cent.

Is it any wonder that the oil majors have taken over as Public Enemy No. 1 from heartless bankers, rapacious hedge fund managers, and public employees? Hence President Obama’s proposal to strip the industry of the tax advantages it currently enjoys, and hence today’s testy dog-and-pony show on Capitol Hill.

Big Oil’s guilty of being obvious in another sense too—the low price the market currently attaches to its future profits is there for all to see, as is the strong emerging-markets growth pumping up long-term oil demand and the depletion of the easily accessible reservoirs capping supply.

Jeremy Grantham may be right about us not being prepared for the coming resource crunch, but the same can’t be said all the speculators swarming commodity stocks and markets.

A lot of speculative money leaning the same way practically guarantees violent shakeouts. Exxon shares bottomed below $57 last July, then ran up 56% over the next ten months.

Over the same span, the Russell 1000 Energy Index, of which Exxon is the largest component, advanced 36%. And the Direxion Daily Energy Bull 3X Shares (ERX), a leveraged ETF designed to triple the daily gain or loss of the Russell 1000 Energy, topped out late last month at a gain of 297% from the July low.

This is the feature of leveraged ETFs never mentioned by the cottage industry of killjoys who like to rehash their drawbacks:

  • It’s true that these volatile trading vehicles can absolutely kill a portfolio with sideways volatility.
  • It’s true that they are most appropriate for short-term, tactical trades.
  • But ERX’s big run demonstrates how the effects of daily compounding can help leveraged ETFs outperform their benchmarks in strongly trending markets over longer spans.

If only we could be sure we’re still in one. An uptrend, that is.

That’s because the ERX is down 22% this month—and this doesn’t, of course, mean that it’s become 22% more attractive. Such leveraged betting slips have no intrinsic value to be toted against the ending price. Their value is strongly derived from the potential future price action, weighted heavily toward the action in the near future.

What can we tell about the likely price action in ERX over the near term? Well, with crude down more than 10% in two weeks, and ERX doing what it’s done, it’s clear that some of the speculative froth has left the building.

Crude could still go to $90 a barrel once Libyan tyrant Muammar Gaddafi departs, as he inevitably must in the not-too-distant future. (It’s hard to pay mercenaries when your crude sales and your bank accounts have been shut off.)  

But the key points there are that there are no guarantees for Libya or any other Middle East oil producer, that Exxon and its rivals can make money hand over fist at $90 a barrel, and that the return of Libyan crude output would be the sort of positive supply shock that stimulates demand.

US demand for fuel has been wilting as of late. But there are too many indicators out there to ignore, from Macy’s (M) to Tempurpedic (TPX), and beyond, suggesting that most consumers are not currently pinching too many pennies.

Let gas fall to $3.50 a gallon and the summer road trips will be back on. This would actually be a long-term positive for Big Oil, which can profit handsomely over the long run from prices that don’t destroy demand or cause the Federal Reserve to tighten prematurely.

Could the ERX still move considerably lower? Of course it could. But Exxon spending $5 billion every three months on share buybacks (just for one example) does provide some downside protection.

 So does the fact that the industry-leading stock now sells for just nine times the current calendar year’s earnings estimates. If it merely returns to its five-year-average trailing P/E ratio of 12.5 sometime next year, that would imply a capital gain of 35% from current levels.

The best time to buy a leveraged ETF is after a shakeout like we’ve just had, for industries still displaying strong fundamentals. The ERX fits this profile at the moment like few others. The risk is sizeable, but then so is the potential reward.

Unless you really believe the economic cycle has topped, the likelihood that ERX will trade significantly higher than its current price over the next few months seems high.

And holders do get to choose when to get out.

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