An Investor's Guide to Oil ETFs

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Oil is one of the world's largest industries. The global economy consumed more than 99 million barrels of crude per day during 2018. An average price around $70 a barrel that year puts the global oil market at more than $2.5 trillion. To put that in perspective, the global economy spent more money on oil than it did on all other commodities, such as gold, iron ore, and coal, combined.

Given its sheer size, and importance to the global economy, many investors desire some exposure to the oil market in their portfolio. However, it can be very challenging to pick the right oil stocks because of the sector's complexity and volatility. Oil prices can go on wild swings that seemingly come from out of nowhere. From 2014 through 2018, for example, crude prices suddenly crashed twice by more than 40%. Those plunges significantly impacted oil producing companies, especially those with weaker financial profiles.

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If an investor chose the wrong oil stock, they could have lost everything. One way investors can avoid picking the wrong oil stock by investing in an exchange-traded fund focused on the oil industry. This guide will help investors better understand how they could benefit from this investment strategy.

What is an exchange-traded fund?

An exchange-traded fund, or ETF, is a stock-like security that tracks a certain segment of the market or index and is easily accessible to investors because it trades on a major stock exchange. ETFs share similarities to both stocks and mutual funds: They're tradeable like stocks but hold a large basket of equities, bonds, or commodities like a mutual fund.

Some ETFs hold hundreds and even thousands of stocks, providing comprehensive exposure to the entire stock market. The SPDR S&P 500 ETF, for example, tracks the S&P 500 index, a broad market index of 500 stocks. Thus, buying the SPDR S&P 500 ETF enables investors to own a stake in all 500 of those companies.

Other ETFs, meanwhile, will track an index that focuses on a certain segment of the market. Oil ETFs follow the performance of different sets of oil stocks or the price of a barrel of oil. Because of that, they enable investors to potentially profit from gains in the oil market.

Risks of investing in oil stocks

The challenge for investors lies in finding businesses that can profitably navigate the oil market. That can be difficult because of a range of factors, including:

  • Oil price volatility
  • Rising costs
  • Project management issues
  • Equipment availability
  • Access to capital
  • Government regulations

These issues have impacted the ability of some oil companies to make money even during periods of higher oil prices. As a result, some investors have been correct in the view that the oil industry would continue expanding, but have still lost money because they bought the wrong oil stock, which underperformed its peers due to some company-specific issue.

Why buy an oil ETF?

That's where oil ETFs can step into an investor's portfolio. They take out the guesswork of finding the right oil stock because these entities own shares of several oil companies. That diversification helps mitigate the company-specific risks of investing in a mismanaged oil company that loses money when all its peers are prospering. So, oil ETFs enable investors to express a broad market thesis -- for example, that oil stocks will rise in the coming years -- without having to pick the correct oil stock to profit from that view.

That optimistic view of the oil market isn't farfetched. Despite increasing worries about climate change, the world still depends on oil, which isn't expected to end anytime soon. Oil companies will need to produce as much as an additional 7.5 million BPD from 2017's level by 2025, according to the International Energy Agency (IEA).

Not only will the sector need to meet that growing demand, but it must do so as production from legacy fields continues declining. In the IEA's view, oil companies need to bridge a 35 million BPD gap in the coming years. For perspective, that's more than the current production of the world's top three producers -- the U.S. Russia, and Saudi Arabia -- combined.

That outlook suggests that oil prices need to be high enough in the future to incentivize oil companies to continue exploring for and developing new sources of oil, which should benefit oil stocks as a whole.

Types of oil ETFs

Investors can group oil ETFs into three basic categories:

  1. Oil price ETFs
  2. Broad market ETFs
  3. Targeted sector-specific ETFs

Oil price ETFs

Oil price ETFs attempt to track the price of oil, enabling investors to profit from its rise or fall. The United States Oil Fund LP is one example of an oil price ETF, with it aiming to track the price of oil produced in the U.S. We'll drill down a bit deeper into this ETF later.

Broad market ETFs

A broad market ETF, on the other hand, invests in a large basket of energy stocks, including upstream, midstream, and downstream companies, as well as integrated oil companies that operate across the sector. Broad market oil ETFs typically hold more than 100 oil stocks across the industry, which allows investors to benefit from the anticipated growth in all segments of the oil market.

Targeted sector-specific ETFs

The final type of oil ETF targets one of the three main segments of the oil industry: upstream, midstream, and downstream.

The upstream segment focuses on exploring for, drilling, and producing oil. Companies in this sector include exploration and production (E&P) companies -- which drill for and produce oil and gas -- as well as the oil-field service and equipment companies that provide producers with the tools and expertise needed to find and produce oil.

Several ETFs, including the SPDR S&P Oil & Gas Exploration & Production ETF, focus on E&P companies, while others such as VanEck Vectors Oil Services ETF will only hold the stocks of oilfield service and equipment companies.

The oil and gas midstream sector, in the meantime, focuses on transporting, processing, storing, and marketing hydrocarbons, which include oil, natural gas, natural gas liquids (NGLs), and refined petroleum products such as gasoline and diesel. The Alerian Energy Infrastructure ETF is one fund that zeroes in on this sector.

Finally, the downstream segment focuses on transforming oil, natural gas, and NGLs into higher-valued products like gasoline as well as the building blocks for petrochemicals. The VanEck Vectors Oil Refiners ETF is one of a few ETFs focused on this segment of the oil market.

Sector-specific ETFs allow investors to target an investment that should be profitable if a particular thesis plays out. For example, if an investor believes that higher oil prices will drive a rebound in drilling activities -- and therefore fuel higher profits for oil-field service companies, pushing up their stocks up in the process -- then they can express this view by investing in an ETF focused on this oil-field service stocks. That targeted yet broad-based approach will avoid a situation where the thesis plays out as anticipated with most oil-field service stocks rising, except for an investor's chosen company, which underperforms its peers because of some unexpected issue.

How to choose the right oil ETF

With so many oil ETFs out there, investors face a daunting task in picking the best one for their portfolio. One way to narrow the field is by looking for the following three criteria:

  • A low expense ratio: Investors pay ETF managers a fee to manage the fund. The lower these fees, the better, because they will eat into an investor's return over the long term.
  • At least several hundred million dollars in assets under management: Trading liquidity can be a problem with smaller ETFs, which is why it's better to choose a larger fund, so that this doesn't become an issue during periods of market turbulence.
  • A solid history of tracking its benchmark: Most ETFs track a benchmark, whether that's the price of oil or a market index. Look for ETFs that have closely mirrored theirs over the past several years.

The top 10 oil ETFs

Dozens of ETFs hold oil stocks, giving investors a wide variety of options. The largest by assets under management are on the following table:

Oil ETF

Assets Under Management

Expense Ratio

Number of Holdings

What It Tracks

Energy Select Sector SPDR Fund (NYSEMKT: XLE)

$13.4 billion

0.13%

30

Energy stocks in the S&P 500 index

Vanguard Energy ETF (NYSEMKT: VDE)

$3.5 billion

0.10%

141

The performance of the U.S. energy sector

SPDR S&P Oil & Gas Exploration & Production ETF (NYSEMKT: XOP)

$2.1 billion

0.35%

69

Oil and gas E&P companies in the U.S.

United States Oil Fund LP (NYSEMKT: USO)

$1.6 billion

0.76%

1

The U.S. oil price benchmark West Texas Intermediate (WTI)

iShares Global Energy ETF (NYSEMKT: IXC)

$1.3 billion

0.47%

70

Companies that produce and distribute oil and gas globally

VanEck Vectors Oil Services ETF (NYSEMKT: OIH)

$1.1 billion

0.35%

25

U.S.-listed companies that provide oil-field services

iShares U.S. Energy ETF (NYSEMKT: IYE)

$861 million

0.43%

69

U.S. companies that produce and distribute oil and gas

iShares North American Natural Resources (NYSEMKT: IGE)

$788 million

0.47%

128

North American natural resources companies, including oil, and gas, mining, and forestry companies

Fidelity MSCI Energy Index ETF (NYSEMKT: FENY)

$467 million

0.08%

134

The performance of the U.S. energy sector

iShares U.S. Oil & Gas Exploration & Production ETF (NYSEMKT: IEO)

$347 million

0.43%

66

U.S. companies that produce and distribute oil and gas

To give investors a flavor of the differences between these funds, we'll drill down into the four largest.

Energy Select Sector SPDR Fund: Concentrated at the top

The Energy Select Sector SPDR fund is a broad market oil ETF with a twist: It only holds energy companies included in the S&P 500, which totaled 30 in early 2019. Furthermore, it is a market cap-weighted ETF, meaning that the largest companies by stock market value make up the greatest percentage of its holdings.

This allocation strategy differs from an equal-weight ETF, which invests roughly the same portion of its funds into each stock. Because of this focus and weighting, integrated oil giant ExxonMobil was this ETF's largest holding at more than 20% in early 2019. Meanwhile, its 10th largest holding at the time, midstream giant Kinder Morgan, only had a 3% allocation. So while this ETF provides investors with broad diversification across the oil sector, it does so via the largest oil and gas companies. That leaves it highly concentrated toward the top end. In early 2019, for example, this ETF's 10 largest holdings made up 73.3% of its total assets. While that percentage will fluctuate along with the stock prices of its largest holdings, this ETF, like others weighted by market cap, means investors will have much more exposure to the largest stocks.

One positive benefit of this concentration is that larger oil companies are less volatile than smaller ones, which can help cushion the blow when crude prices fall, as they did in late 2018. On the downside, if one of its largest holdings underperformed, it would be a significant drag on this fund's returns compared to a similar equal-weighted oil ETF.

Vanguard Energy ETF: Low-cost broad market exposure

The Vanguard Energy ETF is also a broad market oil ETF, holding not only the 30 energy stocks in the S&P 500 but more than 100 other oil and gas stocks. However, it's also a market cap-weighted ETF, meaning the largest percentage of its assets are in the biggest energy companies by market cap. As a result, ExxonMobil was also this fund's largest holding at more than 20% in early 2019, while its top 10 holdings equaled more than 67.5% of its total net assets.

Aside from offering a bit more diversification across the sector, another thing setting this ETF apart from most others is its ultra-low expense ratio. That makes it a bit cheaper than the Energy Select SPDR ETF and even less expensive than most targeted oil ETFs. Fees are noteworthy because they eat into returns over time. That's why investors should seek out lower-cost funds like the Vanguard Energy ETF, which should enable them to earn a better total return than a similar ETF with higher fees.

SPDR S&P Oil & Gas Exploration & Production ETF: An equal focus on E&Ps

The SPDR S&P Oil & Gas E&P ETF holds U.S. companies engaged in the exploration, production, and distribution of oil and gas, which means the ETF not only owned E&Ps, but also integrated oil and gas companies, as well as refiners, holding around 70 stocks overall as of early 2019. Another thing that sets it apart from other ETFs focused on E&Ps is that it's an equal-weight ETF. That means it held about the same percentage of its assets (around 2%) in oil giant ExxonMobil as it does in smaller E&P companies.

This ETF is an ideal option for investors who want to target the fast-growing U.S. oil industry. Because it's not concentrated on the largest oil producers, which tend to grow at a slower rate, investors have more upside potential with this ETF. However, with that greater reward comes a higher risk level since this ETF will likely be much more volatile than others, which could hurt returns when oil prices slump.

United States Oil Fund: A short-term vehicle to profit from a big move in oil prices

The United States Oil Fund is a different kind of ETF. Instead of investing in oil stocks, this fund buys oil futures contracts (specifically on the U.S. oil benchmark WTI), which are agreements to purchase 1,000 barrels of crude oil for a specified price and at a future date. These contracts set the market price for oil. So, when an investor reads that oil closed at $50 a barrel today, this actually means that the price of a futures contract to buy 1,000 barrels a month from now closed the trading day at $50.

Because it invests in oil futures contracts, the United States Oil Fund enables investors to track the daily movements of the price of oil. So, it allows investors who believe that oil will go higher in the near term to potentially profit from that view without having to open a commodity futures account.

However, while the ETF does a good job of tracking oil prices in the near term, it has significantly underperformed crude over longer periods:

Several factors caused this drag. First of all, the fund has a much higher expense ratio than most other ETFs, which eats into returns over time. Second, oil futures expire every month, which adds trading costs since the fund needs to continue rolling its contracts forward by selling them just before expiration and buying new ones that expire at a later date. Third, those front-month contracts it's selling tend to trade at a lower price than those expiring in future months (a situation known as contango), which often forces this ETF to pay up to roll contracts forward.

Because of these factors, investors shouldn't use the United States Oil Fund as a long-term investment on the price of oil but instead to make short-term wagers on movements in the market. Those bets can either be bullish by buying the ETF or bearish by shorting it, which an investor can do by borrowing shares of the fund from a broker and selling them in hopes of buying them back later at a lower price after crude prices fall.

How have oil ETFs performed over the long term?

The price of oil has a significant impact on the performance of oil ETFs. During periods of rising crude prices, oil ETFs can significantly outperform the S&P 500. That was the case for the SPDR S&P Oil & Gas Exploration & Production ETF, for example, from early 2009 through mid-2014:

Oil ETFs, however, significantly underperformed the market -- as well as many top-tier oil stocks -- over the next five years because of subsequent oil price crashes in late 2014 and late 2018. Thus, investors do need to pick the right time to buy, so that they get the most out of an oil ETF. Usually, the ideal time comes right as crude starts stabilizing following a market crash. That would theoretically position an investor to profit from the subsequent recovery.

Benefits of oil ETFs vs. oil stocks

While oil ETFs come in a variety of shapes, sizes, and focal points, investors can best view them as a way to target an investment on the oil sector without needing to pick the right oil stock because they hold a basket of them, spreading out risk. This approach reduces the probability that an investor will have the right thesis (i.e., oil stocks are going higher), but the wrong vehicle, since an unexpected company-specific issue such as mismanagement, poor well performance, or balance-sheet problems could cause an oil stock to significantly underperform its peers, even if the thesis plays out as anticipated. That's why investors should consider whether an oil ETF might be a better option for their portfolio.

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Matthew DiLallo and The Motley Fool both own shares of Kinder Morgan. The Motley Fool has a disclosure policy.