The Best Energy Funds To Purchase When Oil Prices Recover

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Includes: BGR, DBO, FCG, IEZ, IRR, PEO, USO, XLE, XOP
by: John Dowdee

Summary

Equity energy funds outperformed commodity based funds during the last energy bull market.

On a risk-adjusted basis, BGR, PEO, and XLE performed the best during the previous energy bull market.

Equity energy funds are highly correlated with the S&P 500, so do not offer significant diversification to a general market portfolio.

Oil up Crude Oil prices experienced an unprecedented advance to over $140 a barrel in 2008 only to be followed by a dramatic collapse to a little over $30 a barrel several months later. After recovering in 2009, the prices was relatively stable between $70 and $110 a barrel until June, 2014, when the price again plummeted, falling to less than $30 per barrel in January, 2016. Natural gas has experienced similar volatility. In the earlier part of the millennium, natural gas spiked to over $15.00 per million British Thermal Unit (MMBTU), only to fall to about $2.00 per MMBTU in 2012 and again this year.

Why would anyone want to invest in volatile commodity? Warren Buffett provided a possible answer when he opined: "Be greedy when others are fearful." This snippet of market wisdom have become overused but has never been truer than now when you consider the recent crash of oil prices, and, by association, energy stocks. Maybe it's time to be greedy. This article will present some data that may help you make your decision.

I am not clairvoyant and have no idea how long it will take the energy sector to recover. The slump has already lasted 18 months with no end in sight, especially since Iran is gearing up to produce over a million barrels per day. However, I am confident that over the long run, oil prices will self-correct as companies curtail production. The turmoil in the Middle East is a wild card that could also dramatically reduce supplies if fighting reaches the oil fields. So I believe that oil will return to its glory days over the next several year.

To position my portfolio for the future, I have begun accumulating beaten-down energy assets. Rather than individual stocks, I like the diversification you receive from funds such as Exchange Traded Funds (ETFs) and Closed End Funds (CEFs). To assess the "best: energy investment, I analyzed the risk and awards associated with several energy funds. There are many ways to define "best." Some investors may use total return as a metric, but as a retiree, risk is as important to me as return. Therefore, I define "best" as the fund that provides the most reward for a given level of risk, and I measure risk by the volatility. Please note that I am not advocating that this is the way everyone should define "best"; I am just saying that this is the definition that works for me.

There are a plethora of funds dedicated to energy, so I limited my analysis to some of the most popular funds that cover many of the sub-sectors in the energy space. I did not include master limited partnerships, alternative energy funds, inverse funds, or 2X or 3X leveraged funds. There was no need analyze performance over long periods of time since I knew performance would be terrible with oil selling at 12-year lows. I, therefore, decided to see which funds performed the best during the last bull market, from 3/7/2009 to 6/28/2014. Thus, I restricted myself to funds that have in business since March, 2009. The funds I selected are summarized below.

Equity ETFs

  • Energy Select Sector SPDR (NYSEARCA:XLE). This ETF consists of 43 U.S. based oil, gas, and energy services companies. Most (90%) of the companies are large-caps. The integrated oil and gas companies make up the largest portion of the fund (32%) followed by the exploration and production companies (29%). Other sectors represented are the equipment and service companies (17%), storage and transportation (10%), and refiners (10%). This fund lost 39% in 2008. 9% in 2014, and 21% in 2015. The fund uses capitalization weighting, has an expense ratio of 0.14%, and yields 3.4%.
  • SPDR S&P Oil and Gas Exploration and Production (NYSEARCA:XOP). This ETF focuses on companies devoted to finding, producing, and retailing oil and gas products. This ETF is based on an equal weight index of 80 companies and includes a relatively large proportion (60%) of small-cap firms. Large cap firms make up only 19% of the fund. This fund lost over 42% in 2008, 29% in 2014, and 35% in 2015. The expense ratio is 0.35%, and the yield is 2.2%.
  • iShares U.S. Oil Equipment & Services (NYSEARCA:IEZ). This ETF tracks firms that provide rigs and crews for drilling in offshore wells. This funds is cap-weighted and holds 50 firms. About 45% of the companies in the portfolio are large-cap, 31% are mid-cap, and 24% are small-cap. The fund lost 46% in 2008, 22% in 2014, and 27% in 2015. The expense ratio is 0.43%, and the yield is 2.4%.
  • First Trust ISE-Revere Natural Gas (NYSEARCA:FCG). This ETF has a portfolio consisting of 30 companies that derive a substantial portion of their revenue from the exploration and production of natural gas. The portfolio is equally weighted. The holdings are primarily medium-cap (27%), small cap (32%), and micro-cap (34%). Almost all (87%) are domiciled in the U.S with another 10% from Canada. This fund lost 46% in 2008, 42% in 2014, and whopping 59% in 2015. The expense ratio is 0.60%, and the yield is 4.7%.

Commodity Funds. Note that the all the ETFs summarized below invest in future contracts and investors should understand the peculiarities of trading futures to avoid surprises.

  • United States Oil (NYSEARCA:USO). This ETF seeks to track the price performance of future contracts on West Texas Intermediate (WTI) oil, which is light, sweet crude oil. The fund replicates the performance of the near-month contract except that when the contract is within two weeks of expiration; the fund switches to the next month contract. Note that this fund will not necessarily track the price of oil on the spot market. For example, in 2009, the spot price of oil soared by 76% but the fund only advanced by 14%. This fund lost 55% in 2008, 43% in 2009, and 45% in 2015. The expense ratio is 0.72%, and there is no yield.
  • PowerShares DB Oil (NYSEARCA:DBO). Like USO, this ETF also holds future contracts but rather than rolling over contracts at the end of a month, this funds uses a dynamic strategy based on the shape of the futures curve at the time of purchase. The objective is to minimize the negative effects of contango (a condition where the forward price of a commodity is higher than the current price). This makes the price of this fund more highly correlated with the spot price but how closely the fund tracks spot prices depends on the shape of the futures curve. The fund lost 42% in 2008, 44% in 2014, and 41% in 2015. The expense ratio is 0.75%, and there is no yield.

Closed End Funds

  • Adams Natural Resources (NYSE:PEO). This CEF was formerly known as Petroleum and Resources and is one of the oldest CEFs, having begun trading on the NYSE in 1929. The fund sells at a discount of 16%, which is a slightly larger discount than the 5 years average discount of 14%. The portfolio consists of 40 companies in the energy and natural resource sectors. It utilized less than 1% leverage and has an expense ratio of 0.6%. The distribution is $0.10 per quarter which is only 2.5% but it also typically distributes a large capital gain at the end of the year. Last year the capital gain was $1.08, which brought the yearly distribution to $1.38 or almost 9%. None of the distribution was return of capital (ROC). The fund has an exceptional track record and has paid capital gains for 63 consecutive years and dividends for 80 consecutive years. The fund has made a commitment to pay distributions equal to at least 6% of the fund trailing 12-month average price. The fund lost 42% in2008, 7% in 2014, and 20% in 2015.
  • BlackRock Energy and Resources (NYSE:BGR). This CEF sells at a discount of 13.3%, which is a larger discount than the 5 years average discount of 6.4%. This fund is concentrated and has only 31 holdings, all from the energy sector. About 75% of the companies are domiciled in the United States with the rest primarily Canadian and European companies. The fund utilizes less than 1% leverage and has an expense ratio of 0.6%. However, the fund may use options to enhance dividend yield. The distribution has been $0.135 per month but was dropped to $0.11 in August. The distribution this year is expected to total $1.32 (12.4%). Unfortunately, the recent distributions have been mostly return of capital. The fund lost 48% in 2008, 8% in 2014, and 32% in 2015.
  • Voya Natural Resources, Equity (NYSE:IRR). This CEF sells at a discount of 17.5%, which is a larger discount than the 5-years average discount of 7%. The portfolio consists of 84 holdings with 26% from integrated oil companies, 25% from exploration and production companies, and 13% from oil services. About 88% of the holdings are domiciled in the U.S. This fund uses a covered call strategy on about 30% to 80% of the portfolio. The fund does not utilize leverage and has an expense ratio is 1.2%. The distribution a huge 17.4%, consisting primarily of short term gains and ROC. The average Undistributed Net Investment Income (UNII) is negative but small compared to the distribution.

To analyze the risks and return of these energy funds, I selected the bull market time period from 3/7/2009 to 6/28/1014. The results are shown in Figure 1, which plots the rate of return in excess of the risk-free rate of return (called Excess Mu on the charts) against the historical volatility. To make comparisons easier, I assumed zero as the risk-free rate.

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Figure 1: Risk versus reward in a bull market

As seen from the figure, there is a wide range of returns and volatilities. As is evident from the figure, energy funds had a wide range of returns and volatilities. XOP had the greatest return but also a large volatility. Was the XOP return commensurate with the increased risk? To answer this question, I calculated the Sharpe Ratio.

The Sharpe Ratio is a metric, developed by Nobel laureate William Sharpe that measures risk-adjusted performance. It is calculated as the ratio of the excess return over the volatility (the reward-to-risk ratio if you measure "risk" by the volatility). It is a good way to compare peers to assess if higher returns are due to superior investment performance or from taking additional risk. In Figure 1, I plotted a red line that represents the Sharpe Ratio associated with XLE. If an asset is above the line, it has a higher Sharpe Ratio than XLE. Conversely, if an asset is below the line, the reward-to-risk is worse than XLE.

Some interesting observations are apparent from the figure.

  • The performances of equity funds were much better than the performances of future based funds (DBO and USO).
  • Of the future based funds, dynamically managing contango proved to be a good strategy as DBO beat USO on both and absolute and risk-adjusted basis.
  • The more narrow-based ETFs (IEZ, XOP, and FCG) had a higher return than the broad-based fund but also higher volatility. On a risk-adjusted basis, XLE narrowly beat the other ETFs.
  • Among the CEFs, BGE did the best, and IRR lagged. PEO was not far behind BGR on a risk-adjusted basis.
  • There was no apparent winner when comparing the performances of ETFs versus CEFs.
  • The lowest volatility fund was IRR, likely due to writing options. However, in a bull market environment, IRR lagged, which is not surprising.

In addition to risk-adjusted returns, I also want to assess if adding energy funds to an equity-focused portfolio would provide diversification. To be "diversified," you need to choose assets such that when some assets are down, others are up. In mathematical terms, you want to select assets that are uncorrelated (or at least not highly correlated) with each other. Therefore, I calculated the pair-wise correlations associated with these energy funds. I also included the SPDR S&P 500 (NYSEARCA:SPY) ETF so that I could assess the correlation of energy funds with the overall stock market. The results are shown in Figure 2.

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Figure 2. Correlation of energy funds during a bull market

Generally, the equity funds were about 80 to 90% correlated with the general market. Thus, you do not achieve great diversification by adding energy funds to a portfolio that behaves like SPY. The exception was IRR, which was only 65% correlated. This is due to IRR using covered calls. As you might expect, you get much better diversification by adding commodity funds (like DBO and USO). Thus, I would not recommend purchasing equity energy funds for diversification. Instead, you would purchase them because you believe they are undervalued and will provide superior total return in the future.

Bottom Line

If you believe that oil prices will recover in the future, this analysis shows that you would be better off purchasing an equity fund rather than a commodity fund. However, among the equity funds, there was not a lot of difference in risk-adjusted returns. If you are very risk tolerant, you could venture into high volatility funds like IEZ and XOP (and to a lesser extend FCG) in the hopes of obtaining higher total returns. However, if you are more moderate, you are safer with funds like PEO, XLE, and BGR. At the current time, my favorite is PEO due to its large discount, excellent portfolio, and above average yield.

Disclosure: I am/we are long PEO.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.