Oil Investing: Stocks vs. ETFs

by: Marc Gerstein

Even at times when oil prices are soaring, it's easy to wind up with energy stocks that fall. However buoyant one assumes conditions will be, this group should be approached carefully, perhaps through an exchange traded fund [ETF]. When seeking individual energy stocks, focus on company-specific fundamentals above and beyond broad oil-price trends.

Thoughts late last week that oil might ease in response to a Mideast ceasefire and increased supply from Nigeria reversed this week as those hopes faded and as a Russian pipeline leak fueled new supply concerns, thus reinforcing convictions on the part of many investors to retain significant portfolio exposure to this area. But zeroing in on big-name stocks just to get sector exposure is not the way to go.

Table A shows how easy it was in the past year to go wrong with individual energy stocks even as crude rose from the low $60s to the mid $70s.

Even during the most favorable holding period during the past year, the full 52-week interval, there was still a 35 percent chance of choosing an oil stock that fell despite increases in the price of crude. During more compressed time periods, as the commodity itself experienced more short-term ups and downs, the chances of selecting a money-losing stock rose above 50 percent.

This situation argues for a broader-based index approach, such as those used in ETFs. Table B shows that all three broad energy-based ETFs performed well during the foregoing time periods, in absolute terms and compared to the median performance achieved by energy stocks in general.

Table C shows performance data for more-specialized ETFs, some of which were only recently launched, that specialize in sub-segments of the energy sector.

The oil-producer ETFs got out of the gate quickly. The oilwell servicing portfolios didn't hit their strides on day one, but they fared well in the most recent measurement period.

Knowing how to identify companies that are best positioned to benefit from rising prices is a key to finding above-average stocks in specialized areas such as energy production. Examples of what to look for include quantity of proved reserves, political risks associated with where reserves are located, the pace of production, costs associated with bringing reserves to the surface and transporting them, the relationship between production and reserve replacement, and in the case of integrated companies, refinery infrastructure.

While such factors are undoubtedly important, they can be difficult to assess. But one should not underestimate the usefulness of the same general fundamental data used to assess other companies.

Table D shows the relationship between how oil-producing companies were ranked in terms of various data-points back on July 29, 2005, and how their stocks performed over the course of the subsequent year.

The data shows that all three variations on returns on capital — return on assets, return on investment and return on equity — are at least somewhat relevant to assessing investment merit. Return on investment was the strongest; the best performing oil-producer stocks were associated with the highest corporate returns and so forth. Return on equity and return on assets offered little help in identifying winners, at least under the parameters of this simple study, but they produced powerful clues that could have helped investors weed out potential laggards.

The return data for the oilwell services group as a whole was distorted by exceptionally large — more than 300 percent — gains among some stocks priced below $5. Aside from those, there was a tendency in this group as well for weak share-price performance to be associated with especially poor returns on capital.

Consistent with observed day-to-day market news flow, both groups show a relationship between upward estimate revision and future share-price performance. On the value side, price-to-sales ratios turned out to have been especially useful. In the case of oilwell servicing, both data sets served mainly to spotlight potential laggards.

While this is not an exhaustive study, it does at least suggest that objective data-driven algorithms such as ratings and screens might be helpful. Table E reinforces that.

Generally speaking, the stock screens maintained on reuters.com have been effective in distinguishing between potentially strong and lackluster energy stocks. The differentiating capability improves if we drop stocks priced below $5, which are most prone to extreme share price movements, from consideration.

Table F shows oil-related stocks currently appearing in at least one of the Reuters Select stock screens.

Disclosure: At the time of publication, Marc H. Gerstein did not own shares of any the aforementioned companies or ETFs. He may be an owner of one or more companies, albeit indirectly, as an investor in another mutual find or Exchange Traded Fund.

This is independent investment and analysis from the Reuters.com investment channel, and is not connected with Reuters News. The opinions and views expressed herein are those of the author and are not endorsed by Reuters.com.