The Invesco Dynamic Energy Exploration & Production ETF (NYSEARCA:PXE) made headlines as one of the best-performing exchange-traded funds in 2022 with a 60% return, benefiting from the environment of elevated oil (USO) and gas prices. Historically, PXE has also managed to outperform several energy sector benchmarks, including larger and more widely followed ETFs.
Part of the attraction is the fund’s unique quant-based strategy that screens stocks to identify companies best positioned to generate positive returns. Indeed, the results speak for themselves leading us to take a closer look. What we find is that with a trading history going back to 2005, PXE doesn’t always outperform over every timeframe, but the fund does a particularly good job during bull markets. From there, we’re bullish on the energy sector and like PXE’s current positioning into 2023.
What is the PXE ETF?
PXE technically tracks the “Dynamic Energy Exploration & Production Intellidex” which is a proprietary index developed and sponsored by the Intercontinental Exchange, Inc. (ICE), owner of the “New York Stock Exchange”. In this case, Invesco is the investment advisor tasked with following the index and managing the fund passively.
The idea of the model is to identify high-quality and healthy energy sector companies with the best chance for capital appreciation. Through a combination of traditional financial metrics and other fundamentals, the model also includes technical factors such as momentum. In all, five categories of “Superfactors” are considered:
- Price Momentum: Considering the recent stock price performance
- Earnings Momentum: Across trends in analyst estimate changes, cash flow surprises
- Quality: Capturing metrics like return-on-equity, and financial margins
- Management Action: Fundamentals including total dividends paid and levels of share buybacks
- Value: Valuation fundamentals in ratios across price-to-book value, revenues-to-enterprise value, and cash-to-equity.
The 30 highest-rated stocks are included through a quarterly review and rebalancing. Finally, each position is fundamentally scored as an input into a modified equal-weighting approach.
Going through the PXE underlying portfolio, the holdings include high-profile industry leaders across upstream and downstream players. The largest current position is in Marathon Petroleum Corp. (MPC) with a 5.6% weighting, followed by Valero Energy Corp. (VLO) at 5.5% and Pioneer Natural Resources Co. (PXD) at 5.3%. By style, there is a good blend with small caps representing about 36% of the portfolio.
The bigger takeaway here is that the overall composition and relative weightings are distinct which leads to a unique return profile, especially compared to the Energy Select Sector SPDR ETF (XLE) as a sector benchmark tracking the energy stocks within the S&P 500 (SPY). On this point, Exxon Mobil Corp (XOM) and Chevron Corp (CVX), are completely excluded from the PXE fund in contrast to their prominent role in most energy sector funds, and notably together representing more than 40% of the XLE fund.
Relative to the alternative SPDR S&P Oil & Gas Exploration & Production ETF (XOP) which passively tracks a broader range of companies including small-caps through an equally-weighted approach, PXE stands out as essentially screening for higher quality names resulting in a more targeted portfolio.
As mentioned, the fund has outperformed since inception although the official returns figure from Invesco shows it modestly lagged the “S&P Composite 1500 Oil & Gas Exploration & Production Index” over the past 5-years and 10-year period. The point here is to say that PXE is good, but temper expectations for it being some sort of silver bullet
One observation we can make is that PXE appears to outperform the upside which has been evident given the sector momentum and performance of the pandemic lows of 2020.
On the other hand, PXE may underperform to the downside with higher volatility in an “energy sector bear market”. One possible explanation is that the unique tilt towards factors like quality and momentum results in a concentration in a segment of stocks that get bid up to the upside, but face deeper decline as valuations reprice lower.
In the context of the current positioning, it’s possible that mega-cap names like XOM and CVC not in the PXE fund, apparently seen as relatively unattractive by the model, can remain relatively resilient during a selloff which would result in a tracking error or spread against the benchmarks.
All that said, the exposure to small-caps and more leveraged producers down the portfolio should be better able to capture the upside during a new rally in the price of oil and gas from here following the recent correction.
Finally, we’ll note that PXE’s dividend yield at 2.9% is below XLE at 3.6% and the Vanguard Energy ETF (VDE) at 3.6%, but compelling relative to XOP at 2.4% or even the Invesco S&P SmallCap Energy ETF (PSCE) at just 1.7%. Again, it’s another consideration investors can weigh when thinking about the pros and cons of any fund.
What’s Next For PXE?
There are plenty of reasons to be bullish on oil and gas. The setup here is that from the large spike in energy prices at the start of 2022, in part driven by the disruptions during the early stage of the Russia-Ukraine conflict, the market has corrected lower.
The more volatility also reflects concerns over global demand but otherwise normalizing supply chain conditions. We can also bring up a global coordinated effort led by the United States to release portions of their strategic petroleum reserves that added to market supplies over the past several months.
Fast forward, the bullish case simply starts with a premise that the sell-off from the highs of 2022 has gone too far. Global inventory levels are recognized as currently tight. Separately, the reopening of China since ending its “zero-Covid” policies is also expected to drive a boost in demand. We can also bring up the still volatile and uncertain situation in Europe.
The upside in our opinion considers a scenario where global macro conditions can improve, with consumer spending and trade activity benefiting from easing inflationary pressures. On the other hand, the “tail risk” scenario where the Russian war escalates into the region would likely add to a new round of supply chain disruptions and place the 2022 high in Brent crude back on the table.
All this is in the context of PXE down about 15% from its cycle high, while most holdings have also been discounted. Ultimately, we expect the fund to outperform the price of oil on the upside based on the operating leverage of the underlying companies.
This point also goes in reverse where a further drop in the price of oil would open the door for a deeper drop in the PXE share price. The key risk to watch would be a deeper deterioration of the economic environment in a deeper recession scenario would likely lead to lower energy prices.
Putting it all together, we think it’s a good spot for an entry into PXE. One of the strongest cases we can make for the fund goes back to its unique strategy where the fund performs well even without holding XOM and CVX. By this measure, PXE can work as a form of diversification for investors holding other energy sector funds. Overall, PXE is a high-quality fund that can work in the context of a more diversified portfolio for energy sector exposure.