Just One ETF: Turning Crude Prices Into Profits With Oil Services

| About: VanEck Vectors (OIH)
Several times a week, Seeking Alpha's Jason Aycock asks money managers about their single highest-conviction position - what they would own (or short) if they could choose just one stock or ETF.

Alejandro Paschalides is founding principal of Carina Capital, a Philadelphia-based boutique global macro hedge fund specializing in the energy sector. Before founding Carina Capital, he worked most recently as an analyst covering healthcare and business services for private-equity firm Pharos Capital Group.

Which single asset class are you most bullish (or bearish) about in the coming year? What ETF position would you choose to best capture that?

The single asset class within the equities space that I am most bullish on in the coming year - and for a longer time horizon as well - is the oil services industry, which includes the equipment and services companies as well as the drilling companies.

The ETF that I feel is the best positioned to gain exposure to this segment of the upstream energy sector is Oil Service HOLDRs (NYSEARCA:OIH).

How does OIH fit into your overall investment approach?

My overall investment approach is to take a long-term macro view at energy supply and demand trends, garner from that a qualitative notion of what sectors look attractive, and then do quantitative analysis to select specific stocks. I recommend OIH to retail investors because it removes the stock picking aspect and provides exposure to an energy sub-sector that I feel is undervalued both in the long and short term.

In my opinion, smaller retail investors should be picking sectors and sub-sectors, as opposed to individual stocks, unless they have a professional finance background or are extremely knowledgeable about an industry and want to use that advantage to stock-pick within it.

Tell us a bit about the industry. What makes it your top pick?

The oil services industry is the most levered to higher oil prices, so, short of commodity futures, they are the most lucrative and direct way to take advantage of a long-term increase in oil prices. In my opinion, oil prices will be going up significantly over the long term.

OIH chartGlobal production has plateaued over the past five years, despite historically high oil prices which in theory should spur increased supply. This suggests that we are reaching a global production peak. The marginal cost of the barrel is also increasing over time, as new resources coming online are more expensive to extract, such as deepwater and oil sands. In traditional economic theory, higher prices spur the use of alternatives.

The problem is that society as a whole, and especially the U.S., is woefully unprepared to deal with higher oil prices. We use oil for virtually all our transportation-related energy, and there are various externalities which keep us locked into the system (i.e. the oft-cited chicken-and-the-egg situation regarding refueling stations). Substitutes like batteries and natural gas in transportation are also inferior from an energy density standpoint.

Couple that with the fact that the turnover periods are lengthy (for example, it takes 14 years or so to turn over the global automotive fleet, and far longer for planes, boats, etc.), and it seems we have very little we can do to protect against a general rise in oil prices. Because there is also a lag to bring on new drilling and gathering capacity, any new or spare capacity available will get bid up tremendously in the event that high oil prices lead to drastically increased drilling. This is what happened in 2008, when day rates for drilling companies spiked. All of this additional profit flows straight to the bottom line.

On a quantitative basis, the sector is very cheap, and because of the oil spill a few of the names in OIH are trading very close to the lows reached amid the market crisis of 2008 and 2009. This seems like a prime opportunity to pick up some high-quality oil service names at very cheap valuations, and OIH is a great vehicle for retail investors to do that.

Are there alternative ETFs that could be used to capture the same theme? What makes OIH your first choice?

I would choose OIH over similar ETFs, such as IEZ and XES, because it has a greater exposure to offshore drillers, like Transocean (NYSE:RIG) and Diamond Offshore Drilling (NYSE:DO), which I feel have been grossly oversold as a result of the oil spill in the Gulf.

There are also ETFs that focus solely on Exploration & Production (E&P), and while I am also bullish on that sector, that sector tends to be far less international in that E&P companies tend to focus on U.S. or other OECD reserves, whereas equipment and services companies tend to have a wider breadth of international clients. Also, because governments like to tax (or, in the case of spills, hold liable) the E&P companies, I believe there is more regulatory risk in the E&P sub-sector.

It's better diversified than some other HOLDRs - but like the other HOLDRs, OIH is also more top-heavy than alternatives (nearly 85% of assets in its top 10 holdings like RIG, SLB and HAL, vs. 67% for IEZ and 43% for XES). Is there a real volatility concern for OIH in particular because of this (from a single-company impact)?

Well, to some extent there is more risk of a single-company impact, but in this case I actually like that. I think DO and RIG in particular have been grossly oversold as a result of the oil spill, and they should do well as the headline risk from that and the resulting moratorium eases over time. Again, we need to drill offshore and these names have sold off as if we are going to phase that out.

I think it's diversified enough that a big fall in one name is not a real concern; these are the biggest companies in the sub-sector, and as such, less volatile than the smaller names. Even with the biggest holding at 15%, assuming that the investor puts 10% of their portfolio into OIH, that one stock would be just 1.5% of their portfolio.

How does your view differ from the consensus industry sentiment?

The current sentiment on the industry, at least the popular sentiment, is very negative. There is a feeling that we are going to start shifting away from oil. The reality is that we are extremely dependent on fossil fuels and while growth rates for the alternative energy sector are high, they are coming off a very small base. As such, our demand for fossil fuels is actually expected to increase, barring a double-dip recession.

It is also important to note that while places like the U.S. and Europe might be seeing their demand for energy peak, there is strong energy demand growth in developing nations, particularly China and the Middle East. In addition, a growing contingency of oil analysts are stating that oil production has plateaued and may decline in coming years. Those that do not expect a decline will at least concede that most of the new reserves are complicated and expensive to extract.

The general market has not priced this in, which bodes well for sub-sectors of the energy space that are geared towards higher oil prices, such as drilling and equipment and services. The trend has always been for increased drilling in times of higher oil and natural gas prices, leading to higher day rates for rigs and higher prices for equipment and services required for each well. If oil supply fails to meet demand, oil prices could spike, and even if supply does succeed in meeting demand, it is likely to be at a higher price than today, due to a shift away from light sweet crude to heavier, harder-to-extract grades, the extreme examples being the oil sands in Canada and the Orinoco. This trend is also visible in natural gas, as shale gas is more expensive to extract than conventional resources.

Although there is a growing trend towards the belief that oil production will peak within the decade, there is a lot of variation with regard to oil price expectations. While not a wholly accurate thing to say, generally I believe you will find that the geologic and scientific community believes a peak in oil production is more imminent than those with a more economic background. Also, economists are incentivized not to make outlandish predictions, because they don’t get penalized for being wrong if everyone else is saying the same thing. I have seen predictions for oil prices that mirror inflation, but there are also reports that say prices could be $200-plus by 2013 (this is a recent white paper by Lloyds of London; Goldman Sachs (NYSE:GS) did have a $200 price target back in 2008, but they have since changed their view). While such price spikes are short-lived, the general trend seems upwards, but with some short-term risk arising from a generally weak global economy.

What catalysts, near-term or long-term, could move the sector significantly?

Obviously, right now there is a lot of headline and regulatory risk given the spill in the Gulf of Mexico and the potential for significant energy reform in the United States, and perhaps elsewhere. These could move the sector significantly. What is important to remember, however, is that the sector could also benefit from increased regulation.

For example, if more stringent regulations require more safety equipment, blowout preventers, or other such devices, a lot of these companies could actually end up seeing more demand for their products, not less. In the long term, the biggest catalyst is energy prices, not just of oil, but of natural gas, because these companies service that sector as well. I think that long-term, oil will become increasingly scarce and expensive, and companies such as those in OIH will see tremendous demand for their services, at higher and higher rates. Higher oil prices lead to drilling booms, as extraction moves from a few big fields to a myriad of smaller fields. This means that capex per barrel increases for E&P companies, and the direct beneficiaries of this are the equipment and service companies.

What could go wrong with your pick?

My biggest fear, much more so than regulatory risk, is the risk of a general market decline or double-dip recession. While I would argue that long-term fundamentals for this sub-sector are extremely bullish, there are short-term triggers that can negatively impact it, the recent drilling moratorium being but the latest example.

Another potential negative short-term trigger is that a lot of drilling capacity was added as oil prices rose, and under-utilization is a real risk should the economy weaken again. I don’t think alternatives can scale anywhere quickly enough to displace fossil fuels’ importance to the economy, so I do not consider that a realistic risk.

A decline in oil production is actually bullish for this sub-sector, because of the trend to shift exploitation from large fields to small ones and from higher quality to lower quality resources. I think the potential for a double-dip is there, but it’s really a question of timing. If such an event were to occur, the Feds are likely to debase the currency to prop up asset prices, which is beneficial to equities because it is likely to result in inflation.

I think that, because this sector has already been beat up due to the oil spill, and oil prices are not too far above the estimated cost of the marginal barrel of $65, that it is likely to outperform other sectors on a relative basis in the event of a double-dip. Because of that, I would recommend that an investor fearful of a double-dip short another sector ETF against OIH, to create a pairs trade that is market neutral. I would short FAA or RTH, since flying and retail are discretionary and negatively correlated with oil prices (so you could benefit both short and long-run). I do however, advocate a net long equity position over time because I think inflation risk is a real threat long-term and should bolster equities prices.

Thanks, Alejandro, for sharing your choice with us.

Disclosure: Carina Capital is long OIH.

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