National Post (National Edition)
PLAYING THE CRUDE REBOUND WITH ETFs
INVESTORS NEED TO WEIGH RISK VS. REWARD
With oil prices on the rise, the temptation to dive in with a simple ETF that tracks the benchmark may seem irresistible. Brent crude is up over 10 per cent year-to-date, after crossing the US$75 threshold on Monday.
That’s a hefty increase already, to be sure, but even if you think there’s room for oil to rise further — and that’s not a given — how should an ETF investor play this rebound?
SHORT TERM VS. LONG TERM
Martin Pelletier, a portfolio manager at TriVest Wealth Counsel, thinks the recent surge in energy prices has a lot do with Saudi Arabia, and the forthcoming IPO of state-owned Saudi Aramco. The world’s top oil exporter recently mused that it would be comfortable with prices reaching as high as US$100 a barrel.
Riyadh’s sudden eagerness to curb supply and, in doing so, cede market share to Western shale producers may be temporary, though, as the regime looks to juice the 2019 IPO. “They’re going to do everything they can, including throwing in the kitchen sink, to get those prices higher,” says Pelletier, who thinks we’re looking at a trading opportunity, but not necessarily an investment opportunity.
Prices may remain elevated for the near term, but Pelletier sees resistance at US$80 a barrel. “It could be a good near-term trade,” he says. “Over the longer term, I do see some risks because I don’t see the current oil price moving much higher.”
That’s a sentiment shared by Daniel Straus, VP of ETFs and financial products research at National Bank of Canada Financial Markets. Straus says he doesn’t see an oil shortage any time soon. To the contrary, he believes prices at their current level should prompt a robust response from Western producers to turn on the taps to meet demand.
Still, if you do happen to believe in a sustained rise in oil, Pelletier would recommend ETFs with exposure to the United States. Longterm potential for shale producers south of the border far exceeds that of Canadian oilsands producers, he says, thanks to a lighter regulatory burden and increased access to markets. (Just look at the Trans Mountain fiasco.)
For investors pursuing this longer-term strategy, Pelletier recommends the iShares U.S. Oil and Gas Exploration and Production Index Fund ETF (IEO), with exposure to U.S. mega-caps like ConocoPhillips, EOG Resources and Valero Energy.
CANADA VS. THE WORLD
When you’re thinking of a regional play in oil, Straus says that currency should be top of mind. That’s because nations with dominant petroleum industries will see a dual benefit from currency appreciation and global oil price appreciation. “You could have a kind of doubling down,” says Straus.
So for bullish short-term traders, the Canadian market is exactly where they want to be. And because Canadian markets are already so heavily weighted in favour of energy, ETF investors shouldn’t feel as though they have to hunt for hidden gems.
Both Pelletier and Straus recommend the plain vanilla iShares S&P/TSX Capped Energy Index ETF (XEG), which provides all the exposure you need to large-cap Canadian producers.
For a longer-term U.S. play, ETF investors can buy into the aforementioned IEO, although that fund also comes with a mid-range fee of 43 basis points. For a cheaper option, Straus recommends the Vanguard Energy ETF (VDE), which also tracks U.S.-based exploration and production concerns, but at a cost of only 10 basis points.
Global energy ETFs are perhaps the safest bet, says Straus, since they diversify away from any particular currency exposure. For global exposure, Straus recommends the VanEck Vectors Oil Services ETF (OIH). The ETF has performed in line with U.S. counterparts, but if the greenback takes a dive over the next year or so, globally diversified ETFs like OIH will provide some cushion.
UPSTREAM VS. DOWNSTREAM
Here, the question again comes down to bullishness. Upstream exploration and production (E&P) companies are going to see the greatest risk/reward from any uptick in oil prices, whereas midstream transport companies or downstream refiners will provide a more hedged bet.
On the E&P side of the spectrum, energy companies are price takers, depending wholly on the price of oil — and they’re leveraged to boot — which means their shares enjoy outsized gains when prices are rising, and steep declines when the opposite happens. For this kind of exposure, Pelletier recommends IEO in the U.S. or XEG in Canada.
Junior exploration outfits and oilfield service providers, meanwhile, offer even more exposure, since they combine the price sensitivity of E&Ps and the volatility of small-caps. For junior explorers, Pelletier recommends the SPDR S&P Oil & Gas Exploration & Production ETF (XOP). For oilfield service providers, he suggests the SPDR S&P Oil & Gas Equipment & Services ETF (XES).
More conservative investors, meanwhile, may prefer to go with a safer midstream or even downstream ETF strategy. For midstream ETFs that track pipelines, he suggests the Horizons Canadian Midstream Oil & Gas Index ETF (HOG).
These types of companies, Straus suggests, rise and fall with oil prices, but don’t bear the full brunt of daily volatility because they’re engaged in longer-term contracts. “Their fates and fortunes are more spread out in time,” he says.
Downstream ETFs like the VanEck Vectors Oil Refiners ETF (CRAK), meanwhile, could even offer a short-term hedge against oil volatility. The ETF tracks the performance of refiners, which can get a temporary boost when their main input cost (crude oil) suddenly drops.
PURE VS. DIVERSIFIED
One of the supposed benefits of the exchange-traded fund is its ability to track a commodity like oil or gold, but Straus warns retail investors against these pure oil plays. Commodity ETFs like the United States Oil Fund LP (USO), which is supposed to track the West Texas Intermediate (WTI) benchmark, are not suited for retail investors, he says.
Any investor will know that USO can swing wildly, just like the underlying benchmark. What they may not know is that USO’s attempt to track the benchmark is imperfect; during periods of intense volatility, the ETF may “decouple” from the benchmark because USO is really buying future contracts and not the commodity itself.
“Anybody who wants to kind of play an oil rebound,” says Straus, “and sees these ETFs that are out there that say simply ‘oil’ on the label of the product, if they don’t understand the way futures work, they could be in for a surprise, and especially if they’re holding for a prolonged period of a couple of months.”