Price
Oil prices are currently at their rarely low historical levels, dipping below the $20 level.
Reasons not to invest in the oil & gas sector now
Historically these levels have not been sustained for prolonged periods of time of 5 years and longer. It, however, does not mean that the price can’t go lower as Saudi Arabia’s oil extraction costs are less than $10. This means that if Saudi Arabia wanted to continue the oil war, it could potentially plummet the price of the commodity by another 50% while remaining profitable.
Another argument that can help explain the decrease of capital inflow into the oil & gas industry is that the industry has fallen out of fashion. Climate change activism is high and as a result, many fund managers see the clients’ demand for “environmentally dirty” portfolios decline. It certainly possible that at some point, the oil industry would be suffocated as a result of political lobbying. This scenario has already been played out for nuclear power (arguably, much cleaner than oil) in certain countries.
Reasons to invest in the oil & gas sector now
In contrast to the difficult-to-predict future politically-driven developments, the economic conditions are subject to less uncertainty.
The US Energy Information Administration continues to expect growth in energy production from oil products, albeit representing a diminishing share of the overall energy consumption. Particularly noticeable is the expected growth of coal that represents a much “environmentally dirtier” source of energy that comes not only from the developing countries but also from advanced economies, such as Japan. Long-term demand for oil outlook remains positive.
The supply of oil is, however, severely impacted by the current price. Sub-$20 prices would make most players uncompetitive, especially the US shale oil producers. This would lead to further declines in the production capacity, reducing the ability of supply to catch up with the demand fast.
Lastly, in an inflationary environment (that is reasonably likely to result due to the QE and other government intervention as well as due to de-globalisation), the commodities tend to perform better than other asset classes.
Best ways to get oil exposure for an amateur investor on the London Stock Exchange
WTI vs Brent
Brent and WTI are 2 most quoted crude oil prices. Brent oil price is the benchmark for African, European, and Middle Eastern crude oil. Its price dictates the value of 2/3 of world oil production. WTI is the benchmark crude for North America. Prices of other types of crude oil are determined based on the price of Brent, WTI, or a combination of the 2.
As seen above, the two are closely correlated. Most of the time, the difference in price stays within $10.
Equity ETF vs futures-based ETC
The 2 most common ways to obtain exposure to the oil price is by purchasing an equity ETF or a futures-based ETC. The spot oil price is not directly investable.
A futures-based ETC provides the most direct exposure to the underlying oil price and thus exhibits higher volatility than an ETF covering the oil sector. It is important to note that the returns of an ETC consist of 3 components: the spot price return, roll yield, and collateral return.
The spot return is obvious. On the contrary, the roll yield is often neglected. The roll yield captures the costs and benefits of having physical oil in possession, such as storage, insurance, transportation costs, and having physical oil ready for immediate delivery in times of oil shortage. The roll yield is driven by the futures curve, or the difference in price of a futures contract across a range of delivery time-frames.
A contango market is one where the cost of owning the physical commodity outweighs the benefit, which is common for commodities.
As can be seen from the chart, in a contango market, the drag on the returns can often exceed 5%. This means that during a single roll period (typically a 5-day time-frame each month during which the current month’s futures contracts are sold and next month’s futures contracts are bought), the net asset value (NAV) of the fund can fall by over 5%. The current level of contango in the oil market is unprecedented and could reduce futures-based NAVs by over 50% in a month. In general, the oil market is prone to prolonged contango periods, thus representing an additional risk to an ETC investor.
This presents a traditional equity ETF in a better light as a way to get exposure to the oil prices. Although there are inherent business risks to equities that are not borne by the ETC funds, they can be mitigated away to a significant degree by purchasing an ETF covering a wide share of the whole oil & gas industry.
Thus one may argue that an equity ETF is an inherently less risky way to obtain exposure to oil prices as reflected in its lower volatility as compared to futures-backed ETCs.
SPDR MSCI World Energy UCITS ETF | WNRG
WNRG is a USD-denominated ETF that holds shares of 131 oil & gas companies, with a large concentration of the largest oil majors.
- 0.3% ongoing charge
- USD 131mn fund size
- Close alternative: Xtrackers MSCI World Energy UCITS ETF 1C | XDW0
It’s important to note that this tracker includes exposure to the US shale gas production. To avoid it, one can turn to SPDR MSCI Europe Energy UCITS ETF (EUR) | ENGY or Amundi ETF MSCI Europe Energy UCITS ETF (GBP) | ANRJ
iShares Oil & Gas Exploration & Production UCITS ETF USD (Acc) (GBP) | SPOG
SPOG is a GBP-denominated ETF that holds shares of 60 oil & gas companies, focusing on mid-size players in the exploration and production sub-industries. It is characterised by larger volatility as compared to WNRG.
- 0.55% ongoing charge
- USD 85mn fund size
WisdomTree WTI Crude Oil | CRUD
CRUD is a USD-denominated ETC that is designed to replicate the return on investing in WTI crude physical oil by use of swaps.
- 0.49% ongoing charge
- USD 932mn fund size
WisdomTree Brent Crude Oil | BRNT
BRNT is a USD-denominated ETC that is designed to replicate the return on investing in Brent crude physical oil by use of swaps.
- 0.49% ongoing charge
- USD 181mn fund size
Conclusion
Oil plays an integral part in the current economy. Despite the growing share of renewable energy, the world is not able to stop relying on liquid sources of energy. With the commodity trading at all-time lows, it presents an opportunity to get exposure to this sector at a lower risk.
The safest way to obtain such exposure is to purchase an ETF consisting of the largest players in this industry. SPDR MSCI World Energy UCITS ETF (WNRG) fits this bill. However, it limits the underlying volatility of the oil prices. Investors that look to benefit from that volatility, would be better off with an ETC, such as WisdomTree Brent Crude Oil (BRNT) that tracks the price of oil much closer, subject to the market not being characterised by a strong contango.
Ultimately, the longer the investment time-frame, the more favourable equity-based ETF are as compared to a futures-based ETC.
