The Best Way To Play Crude Is To Buy Russia

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Includes: OIL, RSX, RSXJ, UPLMQ, USO, XLE, XOM
by: Paulo Santos

Summary

Many are looking to invest in crude, not just for an uncertain rebound but to bet that crude's long-term balance will be reached at a significantly higher price.

However, as I'll show, most instruments which are likely to gain from crude climbing have problems when used to make a long-term bet on crude.

I offer an alternative which I think is better suited for such a long-term bet.

This is a request which comes often. After crude having crashed so much to what are seemingly unsustainably-low levels, people want to know how they might play it for a long-term rebound. It's not that possible investors in it are even driven by short-term considerations. They just feel that at some point it will have to trade higher so that production won't go into a severe decline, and thus they want to be long-term positioned to gain from such inevitable upside.

As it turns out, the answer to this request is far from easy. Consider the following:

Using A Crude ETF Isn't Obvious

In many ways, simply buying crude-tracking ETFs is not a good solution to bet on crude going up in price over the long term. Here are a couple of reasons to avoid using both the iPath S&P GSCI Crude Oil ETN (NYSEARCA:OIL) and the United States Oil ETF (NYSEARCA:USO) for that purpose:

OIL ETF Is Trading Over Its Indicative Value / Intrinsic Value

As I have already covered in my article titled "Do Not Buy OIL, Sell OIL Instead, Or Put OIL Into A Pair Trade," OIL is not trading in line with the prices crude trades at.

To put things in a simple way, let's say crude is trading for $30 per barrel. Buying OIL at Friday's $4.54 close would be rather akin to buying crude at ~$34.20. This is so because OIL trades at a 14% premium to its indicative value/intrinsic value (the crude prices I used above are merely for exemplification purposes, as the actual relationship is more complex).

Putting it another way, were OIL to converge to its intrinsic value (as it should, over the long term) and crude could go up 14% without you seeing any benefit.

USO And OIL Suffer From Rollovers When Crude Is In Contango, As Today

"Contango" in commodities pricing refers to when the near-term futures contracts on the commodity trade at cheaper levels than the longer-dated futures.

The problem for USO, OIL and other such ETFs is that they replicate the returns of crude by using futures (and other derivatives exposed to the same problem). And they do this by investing in near-term maturities. These contracts have to be replaced periodically, and each time these funds replace them (roll them over), they lose money vs. the underlying commodity price evolution.

As an example, let's say you (the fund) are long March crude futures at $29.75/barrel. Come February 22 at the latest, you'd have to replace these futures with April crude futures, which go for $32/barrel. What would happen? Well, you'd have seen crude go from $29.75 to $32 without you making any money on it, simply because the next maturity trades higher (in contango). Now, if crude were to slip to $29.75 again (where you originally invested), you would already be losing ~7% on your investment, and crude wouldn't even have budged from $29.75.

This is the dynamic which produces damage to USO and OIL as long as the contango lasts, and this is also the dynamic which makes them a horrid way to bet on crude going up in the long term.

I had already covered this problem in an old article of mine titled "Contango In Futures-Based Commodity ETFs: A Real Profit Killer." The conclusion remains the same: under the present contango pricing environment it makes no sense to trade USO or OIL except for very short-term trades.

Using Crude-Related Stocks Is Not Optimal Either

Seeing that using ETFs/ETNs or even futures is not the answer to bet on a long-term crude recovery, you might think simply buying E&P (exploration and production) stocks might be the answer.

Well, if crude goes up long term, certainly many such companies will go up with it - there's little doubt there. But then again, like with ETFs, the problem here is that this might be sub-optimal. There are several reasons for me saying this:

  • The largest and safest E&P companies were much less affected by the crude crash. For instance, Exxon Mobil (NYSE:XOM) is down just 22.6% from its all-time high, even though crude plunged by 73% from the 2014 high and 79% from its 2008 all-time high.
  • The smaller E&P companies consistently have bankruptcy risk if the current environment lasts for long. You see it in their balance sheets and their stock and debt price performances. The smaller companies which survive will provide tremendous performance, but many like Ultra Petroleum (NYSE:UPL) might be on their death beds if crude doesn't recover right away. This mostly rules out an investment in individual names unless deep due diligence gives you enough confidence to buy isolated players.
  • Many of the largest companies have a further problem in that they're integrated across the value chain. Now, parts of the value chain like refining saw tremendous increases in profits because of temporary effects, and this buoyed their earnings in a misleading manner. As I've written in my article titled "Valero: The Time To Get Out Is Nigh," there is reason to believe the temporary effects are now fading away. The return to normalcy in other parts of the value chain can thus negate a great deal of benefit from any crude price recovery.

Even if potentially sub-optimal, it might still make sense to bet on crude by using equities. Only then one would probably be better served by using a basket approach, for which owning a sector ETF like the Energy Select Sector SPDR ETF (NYSEARCA:XLE) is a solution.

However, one should understand that this is exposed both to the fact that larger oil companies didn't drop as much (as described above) and the fact that most of those large companies are exposed to part of the value chain having had temporarily-inflated earnings (refining).

The Answer

So, if we can't use crude ETFs/ETNs for the purpose of long-term investing in crude, and even using stocks is difficult, what alternative do we have today?

In my view, the alternative would be to buy Russian Ruble-denominated assets or investing directly in Rubles. This is so for two reasons:

  • The Russian Ruble was deeply punished because of the crude drop. Russia's economy was highly-reliant on crude for its exports and to reestablish trade equilibrium in the context of crude's plunge has meant a deep drop in the Ruble as well. Were crude to start heading up, surely the Ruble would track it to the upside. Furthermore, there are reasons to believe the Ruble itself might be undervalued and primed for such recovery, as described in my article titled "The Russian Ruble Is Another Currency Which Looks Decent Here."
  • Also, if crude was to recover then the Russian economy would recover along with it. This would mean that Russian companies would see favorable fundamental developments alongside a Ruble recovery. Moreover, these companies actually trade at low valuation multiples today to what can be considered a cyclical low in activity.

In short, the Ruble is undervalued, it tracks crude, and Russian companies are denominated in this undervalued currency and are trading for low multiples to earnings earned in an economy that's depressed by low crude prices.

Taking these together, this means that the probable best way to bet on a long-term crude recovery is to bet in Russian stocks. And for an U.S.-based investor, that would mean buying Russian stocks which are quoted in the U.S. through ADRs or ETFs.

To avoid company-specific risk, the probable best way to do this crude-related bet would be to buy market-proxy ETFs like the Market Vectors Russia ETF (NYSEARCA:RSX) or the Market Vectors Russia Small-Cap ETF (NYSEARCA:RSXJ).

I should in particular call the attention to the fact that one could actually be invested in crude ETFs and see crude go from $30 to $40 or $50 per barrel without making any money. However, for the Russian economy and companies, what makes a difference is the ultimate price crude trades at and not how it gets there or how different futures maturities price and evolve. If crude goes up, the Ruble will trade higher, and Russian stocks will trade higher as well.

Conclusion

In my opinion the best way to bet on crude going up over the long term is to invest in Russian Rubles, or more practically for a U.S. investor to buy Russian stocks and ETFs quoted in the U.S. market.

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

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.

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