Oil Exposure In An Equity Portfolio: Does It Make Sense?

Includes: IEO, IEZ, IYE, SPY
by: Marc Gerstein

Are you among the countless recipients of occasional e-mails apparently sent by accident that inform the supposedly-intended and probably-fictional recipient that shares of some tiny oil-and-gas drilling company are about to soar after some sort of big new discovery is announced? The e-mails are, I presume, fake and designed to part the recipient from his/her money. But that should not blind us to the fact that there is a genuine allure surrounding small energy producers; indeed, if the group didn’t have the capacity to excite, the crooks wouldn’t be trying to work that angle. Oil has had its ups and downs over the years, but ever since the initial mid-Seventies OPEC embargo, it’s been hard to look at it as just another sector.

For a long time, oil was seen as a play on inflation (the idea being the best way to protect one’s self against rising prices was to own the thing that leads prices upward), but that faded as the 1980s progressed and inflation became less troublesome in the U.S. Oil was also seen as a play on geopolitical tension, but expect for some unavoidable supply disruptions such as wars that, too, has been dormant more often than not as OPEC nations came to realize that turning off the spigots also meant turning off the revenue flows they had come to cherish. For the most part, OPEC production debates tend to revolve around business philosophy (near-term desire for revenue, long-term inventory preservation, influence of pricing on demand, etc.) rather than geopolitical agenda. That said, geopolitics looks for now to have again moved to center stage as the world wonders if Iran will disrupt transportation through the Strait of Hormuz.

But even aside from geopolitics, oil still has a lot of allure, although there’s now a different and perhaps more classic angle: demand in excess of supply. Politics and emotion aside, demand for energy in general and oil in particular is strongly related to economic activity, and as we moved through the 2000s, we experienced a major structural change: the emergence of new economies. The cranking up of developing nations certainly predates the 2000s, but the last decade saw it on a particularly large scale when China became the new kid on the block. Brazil, Russia and India also did some flexing, but China has so far been at the forefront of this group, popularly dubbed BRIC.

It hasn’t all been smooth sailing. China is trying to cool itself down in order to ward off dangerous overheating. Corruption in India and tensions with Pakistan has so far kept its economic development below potential. Russia, too, has had corruption issues and now has to wonder about a northern version of an Arab spring. And, of course, the financial crisis of 2008 precipitated a sizable interruption in global economic progress not to mention the demise of many speculators who seemed to be driving oil higher than economics alone might have warranted.

Figure 1 shows oil prices since 1986, particularly the gyrations it experienced since 2003.

Figure 1 – Oil Prices

Data from U.S. Energy Information Administration

Figure 2 shows us that U.S. consumption trends fail to explain much of what we’ve been seeing from oil prices.

Figure 2 – Consumption

Data from U.S. Energy Information Administration – Agency’s consumption estimate is based on “disappearance of petroleum products from primary sources.”

The domestic consumption increases shows a very gentle uptrend has been in place long before the 2000s-era oil gains. We see the impact of post-2008 economic weakness and the accompanying decline consumption. It’s real. But it’s quite modest relative to the gyrations we saw in pricing. I suppose by 2100, we will probably have achieved enough conservation to have had a meaningful impact on oil prices. But I’m not really interested in a Jeremy Siegel thing (i.e. I’m not writing a book on Oil Prices for the Long Run). I’m content to suggest conservation (as opposed to temporary usage declines due to recessions and the like) is not likely to have much, if any impact, over the course of any our respective investment horizons especially considering the likelihood that structural declines in the U.S. are likely to be offset by gains in emerging economies (a gazillion new cars on new roads around the world should seriously boost consumption, even if said cars are a heck of a lot more fuel efficient than what most of us drive today).

So going forward, say three to five years, it’s not hard to make a bullish case for oil. Expansion of the roster of global economic players is for real (China may have been be talking of soft landing, but its economy certainly isn’t going away). Figures 3 and 4 show demand trends in OECD and non-OECD countries (more developed and less developed, respectively).

Figure 3 – Liquid Fuels (oil products) consumption in OECD nations

Figure 4 – Liquid Fuels (oil products) consumption in Non-OECD nations

Figures 3 and 4 are important in that they demonstrate that the higher oil prices seen in the mid- to late-2000s were based mainly on bona fide demand-driven factors and not the result of some kind of speculative bubble such as we saw for real estate. Undoubtedly, speculation and other kinds of investment-community attention were part of the oil-price picture (as with all other commodities), and that may have contributed to the sharpness of peaks and valleys. But demand driven by emerging-economies was quite important to the pre-2008 surge, to the financial-crisis collapse (note the consumption and GDP declines in non-OECD nations), and to the recent recovery. Meanwhile, we’ve barely scratched the surface in Africa (South Africa is already trying to turn BRIC into BRICS). The latter may take longer than three to five years, but forecasts of improved development in Africa, already starting to surface, may become more credible and start impacting prices within this time frame.

On the supply front, the best-case scenario is likely to be status quo. But the Arab spring has introduced an entirely new set of geopolitical uncertainties into that region with tension around the Strait of Hormuz being the latest episode. A Russian spring would raise many questions for that oil-producing nation, and we’re also seeing renewed violence in Nigeria, another major oil producer.

Ultimately, oil is not by any means a sure thing. Economic progress will play a big influence, as will demand elasticity (the impact of prices on the level of demand). But it’s probably at least as easy to make a case for oil as for U.S. equities in general. And at least with oil, the economic play is global rather than U.S. centric. As an emotional play (in times of chaos, many like to have ownership stakes in “stuff” rather than less tangible assets), oil may not have quite the allure of gold, but there is something to be said for ownership of stuff the world needs, as opposed to stuff the world desires. (Note though that I don’t mean to disrespect gold; I’ll address that in the very near future.)

The easiest oil play for a U.S. investor is probably the iShares Dow Jones U.S. Energy ETF (NYSEARCA:IYE). That’s the grand generalist in the sector. There are some other major ETFs: iShares Dow Jones U.S. Oil & Gas Exploration (NYSEARCA:IEO), and iShares Dow Jones U.S. Oil Equipment (NYSEARCA:IEZ). But there’s no need to lose sleep agonizing over which one might be best. The correlation of daily returns between IYE, the flagship, and IEO is 0.946, while the correlation between IEO and IEZ is 0.937. English translation: selection via coin toss is likely to be just as effective as selection via analytic judgment. But I’m giving the nod to IYE because it has a longer history, dating back to 6/16/00, as opposed to 5/5/06 for the others. That means I can do more research using IYE, and those who’ve seen my articles before and who know how important stock screening is to me should find it quite natural for me to favor the ETF with the longer data history.

As investments go, having IYE in a portfolio would have been a generally good thing in the past, as we see in Figure 5, which compares IYE to the SPDR S&P 500 ETF (NYSEARCA:SPY).

Figure 5

I know the 2007-08 drawdown looks pretty scary, and it was. Bear in mind though that we’re looking at an arithmetic price scale. In percentage terms, the decline for IYE was 54%, worse than the 48% drop experienced by SPY, but not catastrophically so. On the whole, overweighting oil (i.e. holding IYE, thus adding energy exposure beyond that which is included as part of SPY) has been a good thing and for reasons discussed above, I think it can continue to be beneficial in the future.

But speaking of stock screening, something I mentioned a few paragraphs ago, I’ll be doing some of that in my next article. We’ll see then that as nice as IYE may be as a way to play oil, it is by no means the best we can do. There’s much to be said for the little firms; again, there’s a reason why e-mail scam artists think these might make be useful as bait. The bad news is that chasing tickers you see in spam e-mails is not likely to produce satisfying returns. The good news is that small energy oil-and-gas producers can, actually, be quite interesting, much more so than IYE, if selected on the basis of sensible fundamentals-oriented methodologies. That will be the subject of my next article.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.