The Right Oil Services ETF for Performance and Diversification

By Matt McCall

2010’s 15 percent increase in the price of crude oil helped a plethora of related sectors move higher. One of the biggest winners? Oil services stocks, which include drillers, well management firms, and other related oil and gas product and service providers,

Through the last week of December, the PHLX Oil Service Sector Index is up 23 percent, easily outpacing gains in the oil futures pits and the overall equity market.

Some of the large-cap stocks in the sector were up over 30 percent for the year: Baker Hughes (BHI) and Halliburton (HAL) rose 39 percent and 32 percent, respectively.

Oil Service ETFs Compared: OIH and IEZ

Currently, investors have four oil service ETF options to choose from.

The largest of these, based on assets under management, is the Oil Service HOLDRS ETF (OIH), with over $3 billion. OIH is hardly a model of diversification however, with only 14 stocks, the fund’s top ten holdings make up 91 percent of its allocation. The number one holding, Schlumberger (SLB), comprises 20 percent of the entire ETF — entirely too high for my liking.

This occurs because, unlike the other ETFs we’ll look at later, OIH does not track a specific index. It is a grantor trust, not an exchange-traded fund — a structural difference that leads to this over-concentration in a few key names.

Not only does OIH lack diversification, its performance has lagged its peers. The ETF is up 15 percent year-to-date, well below the other three ETFs in the sector. What’s more, since the beginning of 2007 OIH is down 2 percent, making it the only oil service ETF in the red for that period.

Meanwhile, the iShares Dow Jones US Oil Equipment & Services ETF (IEZ) has approximately $400 million in assets under management. IEZ is more diversified than OIH, as it is composed of 44 oil service and equipment stocks, but the top ten stocks still make up 62 percent of the ETF’s portfolio. Once again, SLB is a dominant factor, with a 17 percent allocation.

Still, IEZ performed the best in the sector in 2010, gaining 29 percent. Its long-term performance is just as bright: Since the beginning of 2007, IEZ has returned a gain of 23 percent for its investors.

But while IEZ may have been atop performer, its high concentration in SLB and its top ten stocks does not make it my favorite in the sector., Plus, its P/E ratio is a bit high, at 26.3.

PXJ, XES: Which Is Better?

At $175 million, the PowerShares Dynamic Oil & Gas Services ETF (PXJ) is smaller than both OIH and IEZ in terms of assets, but overall, the ETF isn’t a bad choice for investors. The ETF comprises 30 stocks, but the top ten concentration is only 46 percent. The fund’s largest holding, BHI, makes up just 5 percent of the entire portfolio.

While the expense ratio is a little higher at 0.60 percent, the P/E ratio is lower at 15.5. In 2010, PXJ rose 27 percent, and since the beginning of 2007 the ETF has returned a modest 9 percent.

Still, better performance can be found in the SPDR S&P Oil & Gas Equipment and Services ETF (XES). The ETF also has the group’s lowest expense ratio at 0.35 percent.

XES is composed of 27 stocks, with just 41 percent allocated to the top ten stocks. What’s more, the largest holding, Weatherford (WFT), only accounts for 4 percent of the allocation. That gives the ETF the best diversification bang-for-your-buck in our pool.

With an acceptable P/E ratio of 17.7, XES is up 27 percent in 2010. The ETF has also done well long-term; since 2007, XES has gained 22 percent, just behind IEZ and easily beating the other two choices.

So when all factors are taken into consideration, IEZ is clearly the best choice in the sector.

Outlook for 2011

With oil prices hovering above $90 per barrel and headed toward triple digits once more, the run for the oil service stocks should remain intact. As the global economy continues to improve, so will the demand for oil and oil service products. The charts remain strong, with the ETFs hitting new highs and the fundamentals (17.7 P/E for XES) also backing higher prices. The key to this sector is buying on weakness and picking an acceptable entry price, should you decide to initiate a position in the ETFs.

Disclosure: No positions