The Best Oil and Gas ETF to Invest $1,000 in Right Now

The Iran war shut down the Strait of Hormuz in late February. Brent crude oil went from around $70 a barrel to briefly over $120 in a matter of days. The SPDR S&P Oil & Gas Exploration & Production ETF (NYSEMKT: XOP) is up nearly 34% year to date over the same stretch, and soaring oil prices are the catalyst.

Understand, however, that oil and explorers don't see their stock prices correlate directly with oil. That's because they're corporations, not commodities, and they've likely hedged their oil price exposure months earlier

But with even higher oil prices a distinct possibility, the environment for explorers and producers to translate those higher prices to the bottom line improves. The International Energy Agency (IEA) has called this the "largest disruption in history." The Iran war shows only on-and-off signs of reaching a resolution, and higher oil prices are not yet fully baked into this sector.

That makes the State Street SPDR S&P Oil & Gas Exploration & Production ETF a buy.

Image source: Getty Images.

How XOP is constructed

This ETF tracks the S&P Oil & Gas Exploration & Production Select Industry Index, which targets companies in the integrated oil and gas, exploration and production, and refining and marketing industries. It currently holds 49 stocks and equally weights the final portfolio.

The equal weighting is key to limiting volatility in a concentrated sector. The State Street Energy Select Sector SPDR ETF (NYSEMKT: XLE) has a lot of overlap with this fund, but it also has a 39% combined weighting in ExxonMobil (NYSE: XOM) and Chevron (NYSE: CVX). That's too much faith to put into just two companies. In the State Street SPDR S&P Oil & Gas Exploration & Production ETF, that combined weight is only 5.2%. In other words, the smallest players get as much influence as the bigger players. That's important for diversifying away unnecessary risk.

The earnings story is still developing

Data source: State Street.

From a structural standpoint, this fund meets all the important criteria for being liquid and tradable. With well over $3 billion in assets, it has more than enough daily trading volume to keep spreads tight. The 0.35% expense isn't Vanguard-esque, but it's reasonable for an equally weighted portfolio of around 50 stocks.

The real story might be the value. The forward price-to-earnings (P/E) ratio of 8.6 is about as cheap as this sector has ever been. The price-to-book (P/B) ratio is about average, historically speaking. But it's evident that recent price gains and revenue/income growth haven't made this ETF expensive by any means.

The longer the Iran war drags on, the more financially beneficial it becomes for the producers. As I mentioned earlier, producers often lock in hedges months in advance to create more pricing certainty. Many of those hedges were likely in place before oil prices shot higher. If they can eventually negotiate new hedges at $80 to $100 or better, that will result in significant revenue growth, especially for the smaller companies in this portfolio.

In other words, we might yet see significant revenue and earnings improvement over the next few quarters.

But any resolution in the Middle East could quickly reverse that. If the conflict comes to an end, oil prices are likely to drop quickly, which negatively impacts the top and bottom lines. With tensions escalating just over the past few days, it looks like the "higher for longer" outcome is the more likely one.

Be prepared to move on an XOP trade quickly

An investment in the State Street SPDR S&P Oil & Gas Exploration & ETF in the short term will depend heavily on geopolitical considerations. The fund is clearly a better buy when oil prices are high than when they're declining. Overall, given its macro outlook, financial conditions, and relative value, this fund is the best buy in this space right now.

David Dierking has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Chevron. The Motley Fool recommends Murphy Oil. The Motley Fool has a disclosure policy.