Booming U.S. oil production in the midst of the oil shale revolution may be hurting oil prices these days, but it’s helping fuel a rally in oil-focused equities. Investors can play either side of the changing energy picture in any way they want due to the flexibility and accessibility of futures-based and equities-focused ETFs.
Other factors besides the 24-year high in production have contributed to the decline in oil prices, such as reduced tensions with Iran and Syria, the recent U.S. government shutdown, as well as lingering concerns about China and U.S. economic growth going forward, says U.S. Commodity Funds’ Chief Investment Officer John Hyland.
While higher production in the aggregate may push down oil prices, hurting the oil futures market and the ETFs that invest in those futures, at the individual company level, that increased output often translates into higher profitability for oil companies, something that is good for them and for the ETFs that own them.
A fund like the United States Oil ( USO | A-100) , for instance, largely considered the U.S. oil benchmark in the ETF market, has suffered the most in recent weeks as oil supplies pile up. That’s because USO invests in near-month Nymex futures contracts on WTI crude oil. USO has slipped more than 4.3 percent in the past month alone.
“As a general thought, the front end of the curve will tend to react more strongly to news, and so move up or down more than further out on the price curve,” Hyland said.
Meanwhile, the Energy Select Sector SPDR ( XLE | A-93 ), for instance, which invests in the equities of companies that drill, produce, refine and transport oil—and gas—has seen gains of 4.25 percent in the same period.
“Energy equity ETFs such as XLE and IEO have performed well in part due to the broad stock market rally,” HardAssetsInvestor.com analyst Sumit Roy said. “But that’s also due to the fact that companies in the ETFs have benefited from the U.S. oil boom. They’ve seen their output surge and this has more than offset any weakness in oil prices.”
Chart courtesy of StockCharts.com
Here’s the bigger lesson:When it comes to investing in oil, investors—and advisors—need to have a clear view on the market, understand why they are looking for an allocation to oil, and only then decide how they’re going to go about getting that exposure.
Hyland would caution that equities-based exposure would translate into overall returns that are far more correlated to the broad stock market than to the dynamics in the oil market itself, but he would also argue that there’s no one-size-fits-all solution when it comes to oil.
USO invests in front-month futures only. It rolls from one expiring contract into the nearest next month, making the fund particularly susceptible to the erosive effect contango has on returns. Indeed, USO’s short-term focus on supply and demand of oil makes it that much more sensitive to volatility. Still, USO remains the largest—at $720 million in assets—and most liquid oil futures ETF in the market today.
Since the beginning of the year, USO has seen total returns of a modest 5.8 percent, only a fraction of the gains XLE, for instance, has seen in the same period. But its performance isn’t by any measure bad—it all depends on what the investor is looking to achieve, Hyland said.
“When it comes to investing in oil, investors have to understand whether crude is in backwardation or contango, and whether they have a short-term or a long-term outlook on the expected price movement of oil,” he added.
In the case of WTI oil futures, which comprise USO, the market is in modest contango right now, which leads to negative roll yield because when a market is in contango, its front-month contract is cheaper than later-expiring contracts.
“In the short run, the daily movement of prices is likely to have far more impact in your returns than the impact of backwardation or contango,” Hyland said. “Over time, however, backwardation and contango—particularly if steep—will impact your returns a great deal more.”
Contango and backwardation would impact returns on all futures-based ETFs like USO, or DBO or even Brent-oil-focused BNO.
In the case of the United States Brent Oil Fund ( BNO | B-56 ), which offers exposure to Brent oil, Brent spot prices have been higher than WTI for some time, although the gap has narrowed recently. However, the short end of the futures curve on Brent slopes down rather than up—it’s in backwardation.
BNO has now slipped 1.14 percent so far this year, although in the past 12 months, it’s gained more than 18 percent, outpacing USO’s 11 percent one-year gains.
Again, these performances pale in comparison with the returns investors have had in oil equities ETFs, although they’re vastly different investments.
XLE tracks a market-cap-weighted index of U.S. energy companies in the S'P 500—names like Exxon, Chevron, Schlumberger and Occidental Petroleum. The ETF has tacked on gains of nearly 23 percent year-to-date, more than four times the returns USO has seen in the same time period.
The fund is now the largest and most liquid energy ETF in the market, with more than $8 billion in assets and more than $800 million in average daily dollar volume. At 0.18 percent in expense ratio a year, and a 1-basis-point average trading spread, XLE is also the cheapest in the segment.
Another ETF in the space with stellar returns is the iShares U.S. Oil ' Gas Exploration ' Production ETF ( IEO | A-67 ), which is relatively top-heavy compared with its peers. The fund’s top 10 holdings make up about 60 percent of the portfolio, and it has now seen year-to-date gains of more than 32 percent.
That's nearly a 10-percentage-point return difference relative to XLE, and one that is most likely linked to the fact that IEO's exposure is more focused on independent oil and gas producers, or the very names that would benefit most from the shale oil boom, HAI's Roy said. By contrast, XLE is heavily allocated to names with larger global footprints, companies that have production profiles so large that its hard to "move the needle" even amid robust U.S. oil output growth, he said.
Either way, XLE’s and IEO’s performance speaks to the strength of the individual securities comprising the portfolios and very little, if anything at all, about oil prices as is the case with USO and BNO, Roy said.