Top 5 Oil ETFs
If you're looking to go long the price of oil or hedge against inflation, you could invest either in a commodity ETF, which tracks the price of oil futures, or an equity ETF with a focus on energy companies. We'll discuss the pros and cons of each approach, and highlight potential risks and upside.
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What's the best oil ETF?
The answer to this question depends, to a large extent, on the outlook for equities.
If you expect interest rates to remain low in the near future, and the demand for oil to rise as economies re-open, you would better off investing in an oil-equities ETF. Oil equities benefit from rising oil prices and production volumes. XLE will help you capture that upside and the multiplier effect in energy producers' earnings per share. GUSH will appeal to investors with a high risk tolerance, as it is a leveraged ETF.
However, if you expect interest rates to rise and equities to experience a correction, you would be better off investing in an oil-futures ETF. In our opinion, DBO is a better pick than USO because it actively seeks to minimise roll costs and maximise roll yields. Although USO only recently started rolling its futures contracts over across a range of maturities, it still doesn't actively seek to optimise the roll.
Regardless of whether you invest in an equity and futures-backed oil ETF, you should always consider the future direction of oil prices. The price of oil depends on the delicate balance between supply and demand, inventory levels and geo-political factors. These can change with little notice, as the unprecedented events of 2020 remind us.
Oil equities ETFs
If you aren't comfortable with the intricacies of the oil futures market, you could turn to energy stocks. Unlike oil futures, stocks can fall when interest rates rise. However, they do provide two additional sources of upside that oil futures simply cannot match:
- You'll stand to benefit from increases in the price of oil as well as an increase in demand, as higher prices and production volumes have a multiplier effect on revenues. In contrast, commodity ETFs only stand to benefit from an increase in prices, which may be tempered by roll costs.
- Because companies have fixed costs (in the form of general, administrative expenses and financing costs), an increase in revenue can lead to an even greater increase in earnings per share. This concept, known as operating leverage, can be a powerful way to profit from a surge in oil prices.
However, investing in individual equities isn't without its risks. You could lose the entirety of your investment in the event of bankruptcy. Investing in an ETF, which holds stakes in a large number of companies, can reduce your exposure to individual names.
XLE (Energy Select Sector SPDR Fund) is the largest energy ETF with over $18 billion assets under management. It seeks to replicate the price performance of the S&P's Energy Select Sector Index. This ETF holds positions in 27 companies engaged in the oil, gas and consumable fuel, energy equipment and services industries. Together, Exxon Mobil Corporation (XOM) and Chevron Corporation (CVX) account for 44% of its assets. XLE has a 0.12% expense ratio.
GUSH (Direxion Daily S&P Oil & Gas Exploration & Production Bull 2x Shares) is focused on companies engaged in oil & gas exploration & production, a narrower segment than XLE. It is a leveraged ETF, which seeks daily investment results of 200%, or 200% of the inverse (or opposite), of the performance of the S&P Oil & Gas Exploration & Production Select Industry Index. This fund caught our attention because the financial leverage it uses will compound the equities' inherent operating leverage. However, this also means it can experience even greater downside volatility.
OIH (VanEck Vectors Oil Services ETF) seeks to track the price performance of 26 U.S. listed companies involved in oilfield services (OFS) to the upstream oil sector. Schlumberger NV (SLB) and Halliburton Company (HAL) account for 31% of its assets. The OFS sector is particularly cyclical, with demand for its services driven by the price of oil, as well as technological advances. This ETF has a 0.35% expense ratio.
Oil futures ETFs
USO (United States Oil Fund) is the largest oil ETF, with a net asset value in excess of $3 billion. With daily traded averaging 5.2 million contracts on the NYSE Arca, it is highly liquid. It has a 0.79% expense ratio. USO tracks the price of U.S. light sweet crude oil, also known as the West Texas Intermediate (WTI). Prior to April 17th 2020, USO was entirely invested in the closest month's futures contact. Following the collapse in spot oil prices, which caused steep contango and high roll costs, USO revised its investment strategy on several occasions. It now invests across a range of upcoming futures contracts.
DBO (Invesco DB Oil Fund) also tracks the WTI price. However, unlike USO, "DBO since its inception over 10 years ago has always used an optimization process in selecting which futures contract to own," said Bloom, Invesco’s director of global macro ETF strategy. When markets are in contango, DBO actively seeks to minimize roll costs. When markets are in backwardation, it looks to maximize the roll yield, by adjusting its roll strategy. DBO's net asset value stands around $500 million with trading volumes on the NYSE Arca exchange averaging around 819,000 contracts. It has a 0.75% expense ratio
The weird and wonderful world of oil futures
If you aren't familiar with the concepts of contango and backwardation, investing in oil futures may not be right for you. A sharp rise in the price of oil could lead to a fall in your ETF's net asset value. Before we touch on these concepts, it helps to understand how futures contracts work.
Unlike gold ETFs, which hold physical gold reserves, oil ETFs buy and sell oil futures rather than physical barrels of oil. A oil future is an agreement to buy a given quantity of oil for a set price, at a future date. The price of a future changes over time, but trends towards the current price (also known as spot price) upon expiry.
Upon expiry, the holder of a future must take physical delivery of the barrels. This can be costly as the buyer needs to cover storage and delivery costs. That's why most traders sell their future at least one day prior to expiry, and re-invest the proceeds into a longer dated futures contract. This process is known as the roll, or rolling over.
The market is said to be in contango when the spot price is lower than the future prices. This can occur because of the storage, financing and insurance costs associated with taking physical delivery. It can also occur for fundamental reasons when traders expect oil prices to rise in the future. Backwardation occurs when the spot price is higher than the futures price. Backwardation and contango can affect an ETF's returns in surprising and unexpected ways.
When you invest in a futures-backed ETF, your return will depend on the following four factors: 1) the spot price, 2) the roll cost or yield (which can affect your total return in unexpected ways), 3) interest income, and 4) the fund's expense ratio.
- Spot price: you stand to benefit from an increase in prices. If prices rise from $100 to $101/barrel, you will lock-in a $1 profit.
- Roll cost or yield: an ETF that invests only in a commodity's front-month futures contract stands to lose if the market is a contango (aka. prices rise). Let's assume that an ETF holds the front-month WTI contract worth $100/barrel. If the second-month futures contract trades for $101, the ETF will lose $1/barrel upon rolling over as it will sell for $100 and buy for $101. Roll costs will eat into your returns. Conversely, you could benefit from a roll yield when markets are in backwardation.
- Interest income: futures-backed ETFs only need to put down a fraction of a contract's value as collateral. They typically invest remaining funds in short term securities, such as Treasuries. These returns are negligeable when interest rates are low, as is the case today. However, interest income provided investors with sizeable returns in the 1980s when interest rates were in the double digits.
- Expense ratio: finally a fund's expenses will eat into your returns. The amount, expressed in percentage terms, is deducted on a daily basis from the ETF's net asset value. The average ETF carries an expense ratio of 0.44%, which means the means will cost you $0.44 for every $1,000 that you invest.
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