Using ETFs As A Safer Way To Play Energy

| About: Energy Select (XLE)
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Deciding the best way to profit in the energy sector is a difficult task. Trading oil and gas futures is a tough fast-paced game with dizzying swings, generally unsuitable for a conservative investor like myself. Picking oil drillers feels like navigating a mine field. Difficult earnings predictions, government regulations, and the looming threat of an oil rig disaster complicate the risk profile. Even energy LPs, considered by some to be some of the most stable energy players have hit hard times. Partnerships like Buckeye Partners (NYSE:BPL) and Suburban Propane (NYSE:SPH) have slid. There are lots of uncertainties that surround LPs, such as the stability of government contracts, new legislation, and uncertainty about future earnings. While MLPs are great income generators, concentrating too much of one's portfolio in them is dangerous.

Most conservative investors choose to play oil through the giants. Exxon Mobil (NYSE:XOM), Royal Dutch Shell (NYSE:RDS.A), Chevron (NYSE:CVX), ConocoPhillips (NYSE:COP), and other mega-cap integrated oil companies inhabit millions of portfolios around the world. And they should, as these companies are fantastic earners, large dividend payers, and an investment in the growing demand for energy worldwide. The swings in these companies tend to be less than in the futures or drillers, and usually with time these companies recover from any snags they might encounter during the course of their long-term growth.

But there is also a dark side. Two years ago there was a fundamentally solid oil and gas company named British Petroleum (NYSE:BP). Many investors considered it on an equal playing field with the others. And why wouldn't they? The numbers were there, the dividend was there, and the future looked bright. Due to circumstances that may or may not have been in BP's control the company suffered heavy losses. This could have happened to any of the major oil players just the same, and continues to happen on a regular basis, like Total's (NYSE:TOT) recent natural gas leak in the North Sea.

Playing foreign integrated oils compounds this risk greatly. Petro Brasil (NYSE:PBR), a company I have tracked for a long time is getting slammed right now. Government issues, currency woes, and weak earnings create massive uncertainty for their future. I am no expert on Brazilian currency, nor do I live in Brazil and understand the political situation. The same holds true for Total based out of France. While it is true these risks hold for any foreign company, the risks are concentrated for integrated oils where commodity prices are so crucial and energy profits can be strongly influenced by the government.

Energy ETFs, like other sector ETFs, reduce these risks by spreading them across multiple companies. However, the swings of consumer staples and other low beta industries are considerably less volatile than oil, making ETFs a prime candidate for this industry. Let's look at a couple of them and list the pros and cons.

My main criteria were diversification, high liquidity, low leverage, low tracking error, and low maintenance cost. I did not want only oil or only natural gas, as that exposes me to higher risks should that particular sector tank (see UNG). My experience has taught me low volume ETFs can be very dangerous if there is a mad dash for the exits. Leveraged ETFs have higher tracking errors. My instincts tell me to stay away from them. After my search through many, I came up with two candidates: Energy Select Sector SPDR Fund (NYSEARCA:XLE) and the Vanguard Energy ETF (NYSEARCA:VDE).

Expense Ratio 0.18% 0.19%
Tracking Error 0.18% 0.11%
Yield 1.70% 1.76%
Volume / Daily 2.5mil+ 100k+
Number of Holdings 46 166

The top holdings are similar between the two except for a higher weighting of COP in the Vanguard ETF by 1.5%. The VDE's 166 positions seem excessive and difficult to manage, but most of the holdings are so small that the difference is almost negligible. The tracking error is lower on the VDE, but both are relatively low compared to other energy ETFs, like the iShares Dow Jones US Energy Sector ETF (NYSEARCA:IYE). The most striking difference is the higher volume of the XLE. This is the icing on the cake and tilts the scales in favor of the XLE. I would rather live with the small tracking error difference knowing that I have extreme liquidity.

There are drawbacks for using ETFs as a way to play oil. The low yield may be a turnoff for income driven investors. Buying a few of the top companies like XOM, CVX, RDS.A, COP, and a few others will increase the dividend significantly. Also, the XLE is affected by swings sometimes greater than a portfolio invested in mega-cap oils due to its holdings in smaller, riskier companies. These are things to consider when investing for the long term.

For short to medium-term trading, the XLE is a powerful tool. The volatility is there, enabling a trader to take advantage of large swings in oil prices without having to turn to the futures market. She can also sleep at night without worrying about major losses due to an oil spill, freak accident, bad earnings, and any number of numerous problems that can affect a single company.

You can use the XLE to decide on your entry point.

click to enlargeXLE Weekly Chart

Or, take the futures route and use the price of oil. When oil hits your price it is the signal to buy the XLE.

click to enlargeWeekly Oil Chart

Each trader uses their own technique to determine when is the right time for a trade. Make sure to use the best medium to achieve maximum returns.

Disclosure: I am long CVX, RDS.A, XOM.