Oil and Gas Equipment Providers Have Pick and Shovel Advantage

The old saying goes that the people who make the most money in commodity booms aren’t the speculators, but the folks that sell the “picks and shovels.” That cliché is proving its worth once again during the current energy boom, and understanding why could have big implications for energy investors.

According to a recent article in the Financial Times, big energy producers are facing a significant headwind in terms of rising costs. The global oil and gas industry is expected to face a 15% shortfall in the number of qualified engineers by 2010, and is already feeling the pinch from rising rig rental fees and other equipment shortages. Already, we’ve seen a number of large-scale development projects cancelled due to costs, delays and related issues.

We know exactly how much costs are rising because we have an excellent index available to measure just that: the IHS/CERA Upstream Capital Costs Index, or UCCI, measures cost inflation for oil and gas projects. The index is up a startling 79% since 2000.

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Aside from a few components, the folks who develop the index at CERA (Cambridge Energy Research Associates) don’t see the prices coming down anytime soon.

"Are we at the top of this period of cost increases?” said Richard Ward, senior director of cost research at CERA. “The answer is, not yet. Based upon these trends, any significant relief on cost increases will not be seen until late 2008/09.”

Why should investors care? Because ultimately, people can decide how they want to play the energy boom—through futures, through buying commodity producers or by buying the “picks and shovels” plays. And recently, the picks and shovels plays have been the right choice.

The chart below compares the performance of three oil-focused exchange-traded funds (ETFs) over the past year:

• the U.S. Oil Fund (USO)—shown in green—which tracks the performance of a rolling crude oil futures positions
• the iShares Dow Jones US Oil And Gas Explorers (IEO)—shown in blue—which tracks the performance of oil-producing companies
• the iShares Dow Jones Oil and Gas Equipment Providers (IEZ)—shown in red—which tracks “picks and shovels” plays supplying the rest of the industry

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Simply put, it’s no contest. USO—the oil futures “pure play”—has struggled to eke out a 14% return over the past 12 months. IEO has done better, gaining 39% on the year. But IEZ—the picks and shovels play—has beaten them all handily, rising 60% in a sustained bull market that shows no sign of ebbing.

Those of us who cover the ETF industry often complain that the industry slices the market too finely, and that giving investors too many choices is sometimes worse than giving them none at all. But as the performance of these three “oil ETFs” show, sometimes, having different choices can make all the difference.

Comments

[Jay King:]

Good article. It is important to note that IEZ includes both equipment and services companies. (The full name is "iShares Dow Jones U.S. Oil Equipment & Services Index Fund".) Yahoo! shortens the name, which is misleading.

What I have found is that if you create a custom index of just the equipment-focused companies, which is 26 stocks total, that they do outperform the broader equipment + services funds like IEZ, which further re-enforces the point of the article.

2007 Oct 10 08:13 PM