# SPDR S&P Oil & Gas Exploration ETF (XOP) Is More Levered to Oil

By Liam OdalisUpdated

## A higher correlation with oil

It’s very clear that the SPDR S&P Oil and Gas Exploration ETF (XOP) has a higher correlation with crude oil than VDE, XLE, or IYE—both from fundamental and structural perspectives. Investors can also perceive the security as “riskier” and more commodity price–sensitive.

First of all, since XOP’s top constituents consist of pure-play exploration companies like Sanchez Energy (SN), Laredo Petroleum (LPI), Bill Barrett (BBG), and SM Energy (SM), it’s much more exposed to the upstream energy segment. Secondly, since these companies are smaller than the integrated players, they tend to have higher betas (explained below).

It’s very apparent that the historical beta of XOP is higher than that of its peers, as it’s closer to 1.6 in the chart below than the average of 1.2. Beta measures the volatility, or more specifically the systematic risk, of either a security or a portfolio in comparison to the stock market (the S&P 500). Beta is the correlation coefficient of the security or portfolio’s returns over those of the S&P 500. It’s used in the capital asset pricing model (CAPM), which is a model that can calculate the expected return of a stock or asset based on its beta and expected market return assumptions. A higher beta is associated with a higher expected market return, which usually means a lower current price and riskier investment proposition compared to the overall market.

Plus, the ETF’s historical return standard deviation is markedly higher than that of its peers. Standard deviation derives from the mean or average of a sample set, and it’s the square root of variance. Variance measures the average distance from which each point differs from the mean. The larger the variance, the larger the data range. Investors use standard deviation to measure total market risk and volatility.

In the graph below, XOP’s five-year return standard deviation is close to 30%, while the peer average is closer to 17% and the S&P 500 is closer to 7%. This means that the total risk or volatility of returns for this ETF has been much higher than peers or the control.

## Volatility

Finally, the volatility below derives from the front month options on each of the ETFs in the comp set. XOP again has much higher volatility than its peers, and 3x that of the S&P 500 at 45 versus 15! This means that investors expect prices to change very sharply for the reference asset, which here is the ETF.

For those of you not familiar with option volatility, we can describe it in two different ways. Historical security volatility can be measured from the movement of a stock over a period. So the 30-day historical volatility is measured from how much the stock has actually moved in the previous 30 days. If the stock moves a lot, the volatility will be higher than if the stock moves very little.

On the other hand, implied volatility derives from the price of an option. The implied volatility is calculated from the difference between the market price of an option and what the price would be, given the other variables within the Black–Scholes option pricing formula (underlying stock price, interest rate, dividend, strike price, cost to borrow stock, and time to expiration). The implied volatility tells you what the market is predicting as the volatility of the stock. If, for example, the implied volatility is currently higher than historical volatility, then the options market is predicting that the stock will move more in the immediate future than it has in the past.

On the more practical basis, when investors buy options, prices rise. When they sell, prices fall. When more investors buy options, implied volatility goes up, and *vice versa*. Implied volatility is always changing. If implied volatility is high, that means more people are buying options, which means more people expect the price to move. Theoretically, when implied volatility goes up, the price of the option also goes up because there could be a greater chance that that option will finish in the money. The front-month volatility of XOP options is very high because the market is expecting volatile moves from its underlying portfolio.

For more information on XLE and the energy sector, please see our **Energy & Power** page!