With the global energy sector still reeling from the largely unanticipated halving of oil prices in the second half of 2014, contrarian investors may feel the time is right to increase their exposure to the commodity.
Practically this can be achieved in one of two ways; either directly, by buying an ETC (Exchange Traded Commodity), or indirectly, by investing in publicly-listed energy companies.
Oil ETCs: Plenty of Options but Beware
There is a range of options available when considering Oil ETCs. But it’s important to understand that, due to liquidity constraints and storage costs, all crude oil ETCs track indices based on futures contracts rather than the underlying price of the commodity. This means that investors’ returns may diverge from that of the underlying spot price.
ETF Securities currently offer exposure to both WTI and Brent futures contracts through the ETFS Crude Oil (CRUD) and ETFS Brent Crude (AIGE) ETCs, respectively. Both ETCs charge an annual management fee of 0.49%, although additional swap and index licensing fees push the annual total cost of holding these products up to 0.99% each.
Despite the potential for deviation from spot prices due to the fact that it tracks a futures index, the ETFS Crude Oil ETC has maintained an impressive correlation of 0.96 with the price of WTI Crude over the trailing five-year period.
Investors concerned about contango – when the price of oil futures is higher than its expected spot price, which can lead to losses even if the price of oil rises – may consider the db WTI Crude Oil Booster (XCT9).This product tracks a proprietary index designed to reduce the effect of contango. Despite a higher total annual holding cost of around 1.15%, the db WTI Crude Oil Booster has outperformed the ETFS Crude Oil ETC after fees since its inception in 2010. Generally speaking, this db Booster offering can be expected to outperform its ETFS counterpart in trending futures markets (i.e. those consistently in contango) but underperform in markets with no clear trend.
Energy Companies: Another Play on Oil
Another option available to investors looking to bet on a medium to long-term recovery of oil prices is to invest in oil companies’ shares. After all, the fortunes of companies like Royal Dutch Shell (RDSB) and BP (BP.) are inevitably tied to the price of oil.
However, the main drawbacks of this approach revolve around the indirect nature of the exposure. Investors must accept a level of ‘idiosyncratic risk’ -remember the BP oil disaster in 2010? BP shares lost almost 50% of their value in the weeks that followed. Additionally, investors must accept ‘equity market risk’, which not only reduces the fund’s sensitivity to the price of oil, but also reduces the potential diversification benefits associated with an investment in the commodity.
Sector ETFs: A Cheap and Diversified Way to Access Oil Companies
There are several sector ETFs that provide cheap and diversified access to oil companies.
One of the most popular options is the Amundi ETF MSCI World Energy EUR (CWE) (Ongoing Charge of 0.35%), which tracks the MSCI World Energy index. The fund offers cap-weighted equity exposure to energy companies listed in the developed world. Geographically speaking, the fund is tilted heavily towards US stocks, which maintain around two thirds of overall weighting.
The fund has a correlation coefficient of 0.57 with the price of WTI crude over the trailing three-year period, suggesting only a moderate level of participation in the price of oil. This is unsurprising when we consider that the fund’s largest holdings such as BP or Royal Dutch Shell are sprawling multinational companies that derive substantial portions of their profits from across the supply chain (i.e. upstream operations, covering exploration and production; and downstream operations, covering refining, processing and marketing), which limits exposure to the price of oil.
Investors seeking a higher level of participation may consider the iShares Oil & Gas Exploration & Production UCITS ETF (SPOG) (Ongoing Charge of 0.55%). Rather than tracking the full spectrum of energy companies, this fund focuses exclusively on those involved in the upstream sector. For example, the largest single holding is currently ConocoPhilips COP, a US-based company that focuses exclusively on the exploration, development and production of oil and gas globally. This additional focus has seen the fund maintain a higher correlation with the price of WTI Crude over the trailing three-year period (0.70) than the Amundi ETF MSCI World Energy fund.
One potential drawback of investing in the iShares Oil & Gas ETF is that it is even more geographically concentrated than the Amundi World Energy offering, with over 80% of geographic weight concentrated in stocks listed in the US and Canada. With this in mind, investors should check existing portfolio weights to avoid unintentionally overweighting the region.
In summary, when using passive products to gain access to the price of oil, investors face a trade-off between purity of price exposure on the one hand and cost and simplicity on the other.
For more information about the dynamics of the futures markets, read Be Cautious with Commodities.
