The best way to profit on higher oil prices... Spoiler alert: Buy oil

April 4, 2018 08:00 AM
ETFs

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Crude oil might have hit the gas pedal, but equity investors have been left on the sidelines as energy stocks continue to struggle even as the price of crude rallies. Energy stocks seem like an easy way to play the recovery in crude prices, but the disappointing performance of most energy funds tells a different story.  

The concept is fundamentally sound; energy stocks historically have a high correlation with the price of crude oil and were pummeled accordingly when crude crashed from $110 a barrel to below $30 at the start of 2016.  And when crude began to rebound later that year, energy stocks came along for the ride with the Energy Select Sector SPDR (XLE) up 28% in 2016, while West Texas Intermediate crude was up nearly 45%. But a volatile 2017 left XLE slightly in the red, while WTI managed a 13% gain leaving investors to wonder if the spark had gone out of their relationship.  

The problem ultimately has more to do with the concentrated nature of the energy sector than anything else since energy stock funds are often market-cap weighted, meaning the largest stocks make up most of the fund and just two stocks — ExxonMobil (XOM) and Chevron (CVX) — make up more than one third of XLE’s portfolio. While not a problem in some markets, neither company has managed to keep up with their nimbler peers and use their operating leverage to boost earnings-per-share.  

Instead, as oil markets have entered a state of backwardation where the futures curve has inverted as traders are willing to pay more for a barrel of oil today than in the future, the smarter trade might be making a more direct investment in black gold.  Exchange-traded products have long been the easiest way for investors to gain exposure to shifts in commodities prices — but at a steep cost — and not one always transparent to most.  While commodity exchange-traded products (ETPs) have historically charged large expense ratios, investors have also been at the mercy of roll yield, the outcome of rolling from one futures contract to the next.  The strategy behind most early commodity funds and ETPs was to own the nearest contract to expiration and then buy the next closest contract before the front month expires. That gives holders of the ETP exposure not only shifts in the spot price of the commodity but the underlying futures curve as well.  

When oil is in contango — which means the price of oil is higher in further out contracts — rolling the contract from one month to the next involves paying an incrementally higher price, which can eat away at returns, limiting the long-term usefulness of a commodity fund. One of the first crude oil tracking funds — the United States Oil Fund (USO) — was essentially flat from 2009 to 2013 while WTI was stuck in a prolonged period of contango, even as its spot price rose more than 112% in the same period. But fast forward to last October when oil again entered a period of backwardation and USO delivered a 24.5% return from Oct. 1 to Jan. 31 compared to 25.2% for WTI, while energy stocks, represented by XLE, were up a mere 10%.

But before using an ETP to get direct exposure to crude oil make sure to read the prospectus carefully as no two funds are exactly alike; not only can they be volatile, but fund sponsors have developed new strategies that attempt to offset the effects of contango by gaining exposure across the forward curve. Two examples include the United States 12-Month Oil Fund (USL), which holds equally weighted crude futures for the next 12 months, while the PowerShares DB Oil Fund (DBO) uses a rules-based index to optimize its futures exposure and minimize contango.  

Energy stocks may be good investments, but if your reason for investing is a belief that the price of crude oil will go up, it’s best to simply buy crude oil.   

 

About the Author

Matt Litchfield is content editor for ETF Global (ETFG.com) and is responsible for all posts and new product updates on ETFG.com. @ETF_Global