Boom Time For NRGU As Big Oil Makes A Comeback
Summary
- Since my initial coverage of Bank of Montreal’s specialized ultra-leveraged oil ETN, global energy has been on a tear.
- One of the best performing asset classes in 2021, energy focused securities have witnessed tremendous upside.
- But gains so swiftly generated should not obscure some of the key risks around exchange traded notes.
- We take a macro look at energy and review NRGU’s recent success.
Brief overview
When I initially covered (NYSEARCA:NRGU) – BMO MicroSectors US Big Oil Index 3x Leveraged ETN, I emphasized my bearish outlook. This was not because my outlook on the asset class is resolutely bearish – to the contrary, any inflationista like myself by default has a bullish opinion on global energy.
The key issue for my bearish outlook is the actual security itself and its underlying characteristics. Some reader questions have also underscored a requirement to emphasize some of the central risks to holding leveraged exchange traded notes.
But before doing so – let us have a recap on what oil and the ETN have done over the past three months.
Macro Recap
Oil in its broadest sense has been one of the best performing asset classes at the start of 2021. Surprising, given some of the changes we have witnessed. The Biden government, now well positioned to start enacting its election manifesto, has effectively put renewable energy and the green revolution very much at the heart of policy.
So, what explains big oil’s recent ascent and some of the headwinds faced by classic renewable energy plays?
A multitude of macro factors laid siege to the global energy industry in 2020:
- The global energy asset class lost about 30% last year, being one of the key index laggards. As the SARS-COV2 outbreak spread throughout the world, economies shut down, transport seized up and global energy markets stalled. By April, we witnessed a first for US light oil futures markets, with negative print on the front month futures contract as storage capacity in Cushing, Oklahoma become saturated and demand for offshore tanker storage skyrocketed.
- OPEC and Russia, one of the most important non-member states, had a well-publicized strategy disagreement which led to a mini-price war, creating in hand a wave of bankruptcies across the North American shale patch.
- As US equity markets imploded, the US dollar somewhat strengthened laying the macro-backdrop for continued crude weakness. By this time, several rounds of layoffs were occurring in the global energy industry, possibly rather precipitately.
- As companies looked to shore-up working capital, investment projects and capital expenditure froze up for the later part of year, laying the building blocks for what has been a momentous run in oil prices to the upside.
- The ESG movement started to gain considerable traction as investors looked for more innovative ways of putting capital to work in a tumultuous period for equity prices.
Since then, additional events have all conspired to push oil from its 2020 doldrums.
- The huge internationally coordinated effort to develop vaccines to counter the SARS-COV2 pandemic has seen marked success; in the space of around 12 months, pre-development work on potential cures for the hyper contagious pulmonary influenza strain has paved the way for multiple clinical solutions, all with varying degrees of efficacy. This has led to a progressive reprise of certain patches of the economy.
- The Biden government, now firmly in the administrative driving seat, has widely telegraphed its intentions to massively stimulate the US economy into recovery. Just this week, a $1.9 trillion stimulus plan was green-lighted opening the door to investments in social aid, infrastructure, health, and public service. Any stimulus package of this magnitude comes with inflationary trappings.
- The Federal Reserve has continued its rampant campaign of sovereign bond purchases to the tune of around $80B per month. The widely followed Fed balance sheet must be around $7 trillion at the present time.
- The $US dollar has come under a degree of pressure – thwarted by a continued current account deficit, hyper loose monetary policy, and an inclination by other super-powers (Russia, China) to trade in currencies ex-dollar. While reserve status is not presently at threat, these actions in addition to a fiscal bazooka could lead to dollar woes in the next decade.
- Under investment, particularly in the US shale patch, which was adversely affected by the rapid 2020 drop in crude oil prices, sets up a potential rebound as global economies come back online.
In summary, the dollar has weakened, the economic reprise appears to have gotten off to a better start than envisaged, bond yields have risen, and inflation has started to slowly creep up on the world economy. Global oil was coming from a long way back given its tumultuous 2020, so the remarkable upside seems somewhat comprehensible.
So how about BMO MicroSectors US Big Oil Index 3x Leveraged ETN?
ETN Recap
BMO MicroSectors US Big Oil Index 3x Leverage ETN has boomed, propelled by its extreme leverage. It has played out extremely well for traders but should not detract from the real risks that holding a long-term security like this can have. Leverage most definitely cuts both ways and while it is great celebrating success stories where underlying leverage has gone in one’s favor, the make-up of the ETN continues to have very risky characteristics.
The past 6 months clearly indicates how aggressively oil prices have moved to the upside. Over a comparable period, the ETN is up 280%
Source: Tradingview
Judging by the recent performance of the exchange traded note, it is easy to get carried away by the explosive returns. Notwithstanding, had you held the security during 2020, you still would have incurred massive losses. A $100,000 holding at the start of last year would have left ~$7,870 in capital remaining by year end. Despite superlative 2021 performance thus far, that capital would only be around $22,000, demonstrating the extent of the losses had the asset been held over the past 15 months.
Investor advisory notice MicroSectors Fact Sheet
Source: BMO ETNs
I emphasized this in my previous post, and it is arguably the most important product takeaway – this is not an investable asset, implying it cannot be held for the long-term. It remains a (relatively illiquid) trading instrument for those seeking near term exposure to movements in oil prices. Given the limited optionality the product touts – for example, there is no options market for the ETN – better tradable assets exist to take a short-term risk-on approach to oil.
For investors looking to develop a buy and hold strategy on the back of the macro-factors I emphasized earlier, I recommend a more liquid, versatile security such as (XLE) – the Energy Select Sector SPDR fund by State Street Global Advisors. This is an investable asset which has good liquidity and an options market which allows investors to tailor risk exposures. Clearly, do not be misled into believing past returns on a leveraged exchange traded note, are an indication of future returns.
Historical ETN Analysis. Note that YTD return for the 2 periods is distinguishable – 2020 v Q1 2021 for illustrative purposes only
Source: Spreadsheet developed by author data via ETF.com
The ETN, which is a hyper leveraged mid-cap play on energy, has attracted increased interest as crude oil prices have moved to the upside. Over the past 3 months, fund inflows have increased almost 2x, pushing assets under management to around $500M. Daily volumes have followed suit, yet surprisingly, given the (relative) additional liquidity, spreads have increased. This appears somewhat counterintuitive.
The ETN covers a blend of equities from mid-cap to mega-cap with primary exposure to US energy markets
Source: ETFDB.com
Key Takeaways
- The global energy industry, which had a roller coaster 2020, is shaping up to be one of the best performing asset classes in 2021.
- The sector has come from a long way back, having lost around -30% during 2020 which was marked by a global health pandemic, a shuttering of economies and a freezing up of international transport networks.
- Yet a range of macro factors are conspiring to push energy higher in 2021 – vaccines are starting to be aggressively rolled out, economies are progressively reopening, the US government has latterly green lighted a huge fiscal stimulus initiative and the Federal Reserve continues to support the economy with extremely loose monetary policy.
- While inflation has not yet been widely registered in economic data, bond yields have most recently been pushing north, perchance laying ground for inflation.
- Potential dollar weakness, driven by a range of fiscal and monetary policies, may provide additional tailwinds for global energy well into 2021.
- For the time being, OPEC has shown restraint in energy policy, which has supported energy prices.
- The shuttering of global economies has led to a relative lack of investment in energy assets which may adversely impact supply as the world reopens.
Source: Ole Hansen, Saxo Bank Commodity Strategy Chief
The past 15 months have provided one of the most tumultuous periods for the global energy industry. From bust to potentially a new gradual boom cycle, opportunities abound for money managers to take on long risk in the asset class. And because of the multitude of options available, the limitations of NRGU and its leveraged nature, it is best worth looking at alternatives should you seek to speculate on oil’s lasting reprise well into 2021.
This article was written by
Analyst’s Disclosure: I am/we are long CL1:COM. 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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