stig-brodersen

by Stig Brodersen

As a value investor I’ve learned to first look at sectors that are widely unpopular, and recently, oil has earned that title. Since the beginning of 2013, where a barrel of WTI traded at $93, the price is now cut in half, and it inevitable raise the question: Is this the time to invest in oil?

I’ve given this a lot of thought. It simply didn’t make any sense that oil can be trading for $40 in the long run. At that price it’s not profitable for most companies to drill for oil, and the lack of supply should drive the price up again. This is especially true if the demand is proportionally growing with the global population.

Morgan Downey and Stig talking about the current conditions in the oil market

Well, perhaps it’s not that simple. I remember buying into oil in 2013 in the $90 range where it had recently dropped from $105. I was sure that the oil was bound to sky rocket soon. Having traded at $145 before the crash, and with the economy slowly recovering it was bound to happen right? I had never been more wrong! Instead, the oversupply (relative to the global demand) has severely driven the price down.

WTI oil PriceI’ve learned from bitter experience to be humble and listen to people a lot smarter than me, so I decided to call up Morgan Downey, the author of Oil 101 and CEO of Money.net, to ask him how he thinks investors can play the eventual oil rebound. My objective was simple: First outline if the oil price is below its long-term equilibrium, and if yes, how I should position myself in the market.

This is what I learned: The oil price is indeed undervalued in the $40-$50 range. It simply can’t be sustained in the long run. Obviously, this creates a paradox where one has to define what “the long run” really is. We have plenty of oil in the world, but some of it is very hard to get a hold off. It might be located off shore, and sometimes even in environments that complicate the exploration – for instance in the arctic area. It’s really just a question of the price of oil. If you can sell a barrel for $300 you surely wouldn’t have a problem paying $200 for it. The lessons from studying the fundamentals are therefore quite clear. The price of oil has to increase – but again so does the cost for the oil companies. So what to do now?

Why you shouldn’t play the oil rebound with futures
Morgan was quite clear in his investing approach. For individual investors that thought that the price of oil should increase with a widening gap to the costs one should look closer into ETF’s with “real companies”. Perhaps the best way to explain this is by outlining how you shouldn’t invest in oil. It’s not only a question about which direction you think the oil price is heading, but also which instruments you use to capture the movement. Stocks for instance can be held indefinitely and is a piece of a real business that creates value, and send the corresponding value creation (profit) back to the owner in the form of dividends or capital gains. Oil is a physical commodity that really doesn’t compound when it’s produced. It has industrial and consumer utility, but it’s really in its own bucket when it comes to investments.

Oil is typically traded in futures, which means that you commit yourself to buy or sell, say 1 barrel of oil in 1 year at the given price. Futures contracts are not held indefinitely like a stock, but have a fixed delivery date. That creates a problem for investors that believe that oil will rebound, as they are forced to constantly trade futures, which is costly in fees, and you have to be right on the timing. And wait… it actually gets even uglier when you read the fine prints. In my example you could trade just 1 barrel of oil, but in reality, a futures contract typically represent 1,000 barrels, and often you have to trade multiple contracts at the same time. It’s a lot of money and friction.

So, let’s return to ETFs to see how futures work in practice for the private investor. Many are holding futures and thereby spreading the costs out to multiple investors, and thereby it allows you to buy investment instrument without having to pay-up for thousands of barrels. A very popular ETF is United States Oil Fund (USO). As such, I don’t think USO is a bad investment – it’s just not the right play for the investor that wants to play the long term rebound. USO is created to track the daily movements because it’s dealing with monthly futures contracts of oil– nothing more and nothing less. Here’s USO’s price plot against the spot price of crude oil when the price of oil increased dramatically from early 2009:

USOAre you surprised? I can understand the confusion. Remember that the future has to expire, so what’s happening when the oil price increases in that every month the cheaper contract is replaced by a more expensive contract, and you lose your gain from the higher price. In the oil industry this concept is known as “contango” but is nothing more than saying that distant future prices runs well ahead of the near future prices. You can of course look for ETFs that is buying longer future contracts if you are bull on the oil price, but in general I think it’s a very inefficient approach.

Which Oil ETF Is the Best to Play a Rebound in the Oil Market?
Right, so we know that futures are not the way to go. I’m more inclined to look in the direction of conventional ETFs made up of businesses in the oil industry. After speaking to Morgan Downey I started to look into 15-20 different oil ETFs all with their own unique virtues. I won’t go through all of them, but I would like to highlight 4 where I think we can get some interesting takeaways:

Chart3
FXN follows a purely quantitative stock selection approach
In theory, I think it’s interesting and potentially very profitable to use a formula when you invest in stocks. So for instance you might look at the overall stock market and rebalance 4 times a year to the 100 cheapest stocks based on their P/E. By removing your own human bias, and being a contrarian to the stock market current flavor for stocks, the investor could historically make a decent outperformance of the market.

The issue is not whether or not an ETF is applying quantitative investing, but the underlying principles. Therefore, I was excited when I read about FXN. However, after reading up upon the strategy behind FXN my interest quickly started to dwindle. The ETF picks stocks from the Russell 1000 index (the 1,000 biggest US companies measured in market capitalization) and ranks the stocks accordingly to factors like price appreciation, sales to price, one year sales growth, and many other metrics.

I really wasn’t sold. The approach that FXN used didn’t seem to be sustainable for me. Even so, I was curious to learn about the results, but with a -0.38% compounded 5 year performance the strategy didn’t appeal to me. The bad news didn’t stop there. The expense ratio is 0.7%, the most expensive in this comparison, and generally a lot more expensive than the overall ETF average of 0.44%. We shouldn’t forget the hidden turnover fees that are not included in the expense ratio. For FXN it’s 72% which means that in aggregate 72% of the portfolio is exchanged with new stocks once a year.

There is no one else that you need to pay for commissions and spreads whenever the portfolio is rebalanced. Now, while we hear that we should avoid all costs, we should always look behind the expenses and ask if we get bang for our bucks? I would gladly pay 1% more in fee if I could turn that into a 2% higher return. I could find no evidence of that in the past performance of the fund, and no promise in the future so I quickly moved on in my research.

RYE tracks S&P 500 Equal Weight Index Energy
The approach of RYE is as simple as it sounds. The S&P divides stocks into categories, and in the category called “energy” RYE equally weights 40 stocks in it’s portfolio and rebalances them quarterly. You might be asking why that should yield better returns. Previous studies show that an equal weight strategy typically outperforms the capitalization weighted index S&P500 with as much as 1-2%. The intuition is that overall stocks that are overvalued will be sold at a profit and stocks that are undervalued will be purchased at a good price.

Equipped with that knowledge I took a closer look at RYE. What really pops out when I first glanced at RYE numbers is the negative P/E. Basically that means that the basket of stocks in aggregate hasn’t made a profit in the previous 12 month. Although oil stocks are under a lot of pressure, this is clearly a red flag of the ETF’s current portfolio. Let’s look at the top 10 holding of RYE:
Chart4
As we’ll see later RYE is much more diversified that VDE and XLE. Here I’m not talking about the sheer number of stocks, as RYE has 40 holdings and VDE has 162, but rather the weight of the top 10 holdings (VDE has in comparison concentrated 63.89% in the top 10 holding). ETFs that don’t track a capitalization weighted index are typically more expensive to manage, and RYE is with its 0.4% expense ratio no different.

As with FXN and many other ETFs, it sadly appears that the higher costs often don’t justify the…weaker performance. I’ll definitely keep an eye on RYE in the future because I’m curious about the performance of the strategy, but I don’t look to enter this ticker as a position any time soon. One more thing to add: The actual strategy of tracking an index doesn’t always pan out for an ETF. That is not always a problem, nor the intention for that matter, since all ETFs by definition are compared to a benchmark. However, when your ETF is passively managed and the goal is to follow that benchmark as closely as possible, you would like to see a close relationship between the net asset value (NAV), which is market value of the stocks in the ETF, and the benchmark. In the previous 5 years RYE has only returned 2.67% compared to the benchmark return of 3.11%.

VDE is your typical Vanguard winner
Vanguard is known for a high quality product with low fees, and when it comes to fees I wasn’t disappointed by VDE (Full name is “Vanguard Energy”). With an expense ratio of 0.12% or just $12 for managing $10,000 it was the cheapest oil ETF I could find. Historically the cheapest funds have outperformed the market because… you guessed it – they are cheaper. I set-out to find if it was also the best oil ETF. Here at the top 10 holdings:
Chart5VDE tracks MSCI US Investable Market Energy Index. The index is made up by large, medium, and small U.S companies in the energy sector. The index is capital weighted, and as shown in the table above that means a huge overweight to companies like Exxon Mobile and Chevron. While the small cap stocks might appear to provide you with a high degree of diversification than the three other ETFs in comparison, a closer look at the top 10 holdings might change your mind.
As a value investors, I don’t believe in diversification for the sake of diversification. There has to be a reason, and I would much rather own one good company than 10 bad. One company that I am a 100% sure share that opinion is Vice Chairman at Berkshire Hathaway Charlie Munger. He has continuously stressed the importance of buying the best stocks, because adding bad stocks to your portfolio would rather dilute your return, rather than give you a false impression of safety.

What is especially interesting about Charlie Munger is that he and Warren Buffett bought a sizeable $3.4B position in Exxon back in late 2013 (which they sold in 2015). Back then Charlie Munger said:

“For all of us that have substantial cash positions currently. What’s wrong with holding an XOM in the low 70s? Energy stocks correlation to equities over the last 20 years has been less than .25 and if you remove the financial crises, its .16. With a 4% dividend yield that is reinvested and share buybacks over time. Isn’t it better than holding bonds or cash over the same time frame? Arguably with less risk. Is there a publicly traded company in the world with a stronger balance sheet? If there is further deterioration in the energy market, would it not be beneficial for XOM shareholders in the long run due to opportunistic acquisitions/partnerships?”

Today Exxon trades at $72 and in my opinion the financial statements look strong as ever. While Buffett and Munger later changed their position away from the stock when they saw the coming oversupply in oil, I would recommend anyone to re-read his comments here in fall 2015 where the stock market is even higher and oil prices are declining even more. Can I see the advantage of not being heavily exposed to Exxon Mobile? Sure, I wouldn’t mind an exposure below 5%. But if I have to be heavily exposed to an energy company right now, Exxon is surely not worst I can think off. If you want to invest in VDE or another market cap weighted index you have to take the good with the bad.

Keep in mind that with a heavy exposure to the top holdings your return is less correlated with the price of oil as you open up for company specific risks. If Exxon or Chevron is responsible for a severe oil spill, your ETF will suffer, even though the price of a barrel of WTI might soar.

Is XLE how to play the oil rebound?
The 5 year performance of XLE is 5.03% and it is the best performing ETF in this blog post. (The ETF called PXI actually did slightly better with 5.90%, but the investing principle seemed unsustainable to me). The principle behind XLE is very simple, as it tracks a market-cap weighted index of US energy companies in the S&P 500. It has done so with great precision as the benchmark has grown 5.05% in the same period. Due to the capping restrictions in S&P500 XLE is slightly more skewed toward mid cap than VDE and does therefore have slightly less exposure to Exxon Mobile.
Chart6Common for both XLE and VDE is that they trade at a somewhat high P/E above 20. The P/E rightfully gets critique for being an inaccurate snap shot and with the current low oil prices that critique might be truer than ever. With a P/E of 22.68 you are looking to get a 4.4% return (0.044 = 1/22.68).

It doesn’t look too good now does it? Well, I’m not so skeptical. Keep in mind that P/E calculations are trailing the last 12 month and are therefore suppressed by the subpar business conditions. Consider this example to illustrate the sensitivity to the price: If your cost of a barrel of oil is $35 and you are selling it for $45, it would only take a price increase of $10 to double your profit. While this example is very simplistic, it shows why the P/E, as a single metric, is not always the best tool.

There are a few reasons why I like XLE slightly better than VDE, though I find them very similar. XLE doesn’t have exposure to smaller companies in the oil industry. The US energy sectors is in a very interesting transition where many of the fracking companies that shot up in recent years has to be refinanced very soon. We don’t have to go back longer than July 2014 to find an oil price above $100 per barrel and companies naturally issuing debt with the expectation of a similar price level. I don’t know what will happen when creditors choose to refinance. I could fear that we will see defaults in companies outside of S&P500, therefore I only want my exposure in larger companies that have strong balance sheets.

Another related reason is the dividend yield, where XLE is currently paying out just above 3%. The decent payout is likely possible because the holdings are generating a strong cash flow. Especially during a time with high leverage and unfavorable business conditions, I like to see a stable dividend payment stream, as more leveraged and unstable companies usually hold on to their cash. You can find the dividend history of XLE here.

I don’t know what will happen in the oil market in the short run. Some people talk about oil prices as low as $20. I think the long-term downside is minimal and the upside is exciting. In today’s overvalued market, a 3% dividend yield seems tempting while you wait for oil prices to rebound. With that said, be sure to stay away from companies that are highly leveraged and don’t have the retained earnings to sustain an even uglier global contraction (which is definitely a concern).

Before you invest in oil
So what to do now? I think it’s important that you consider your asset allocation in equities before rushing out and buying oil ETFs. While you might feel diversified with an ETF that has 100 companies, you should remember that credit cycles impact all companies and asset classes. If we are in-fact experiencing the beginning phases of a credit contraction, he could negatively impact oil companies even more.

What do you do Stig? The honest answer is that I don’t know. I am not interested in S&P500 at the current price level– and I’m not invested in any oil ETF at the time of writing. A few days after the interview I talked with Morgan who asked me to dive into a few oil ETFs that was not a part of this blog post (but seems to be material for a follow-up blog post!). As always, the plan is to do my homework and eventually pull the trigger on the securities that deliver the most value. Right now that might very well be an oil ETF, but until I see a change in the current trend, why rush it?

-Stig
P.s. As usual, I want to hear why my analysis is wrong. If you’ve got some comments or questions about this post, be sure to leave it here on our forum.

2018-02-23T23:18:10+00:00

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