Recently on the Yahoo finance blog Breakout: Jeff Macke and Matt Nesto interviewed energy trader and author Dan Dicker, who’s new book “Oil’s Endless Bid” is set for release this month.
During the discussion Dicker describes the Energy ETFs as the “worst investment on the Planet.” Now, there is no doubt that the flaws of commodity futures based ETFs are well documented, but might there still be a reason to utilize them in your portfolio? Are they really the worst investments on the planet?
One would think the title of worst investments on the planet would be saved for such lofty contenders as: Long Term Capital Management, Enron, Social Security or for that matter the Charles Schwab Yield Plus fund.
Let’s start by taking a look at how a futures based commodity ETF typically works. Rather than holding the underlying commodity directly (such as the case with the popular gold (NYSEARCA:GLD) and silver (NYSEARCA:SLV) ETFs, an ETF such as United States Oil Fund (NYSEARCA:USO) invests in futures contracts. For any given commodity there are a number of futures contracts that are based on different expiration dates. For example you could buy an oil futures contract with an expiration date in May or one that matures in June or perhaps October. Typically the later the maturity of the contract, the higher the price (and in particular higher than the spot price) , this is a condition known as contango. In the case of oil with a cash price of $107.11 you could buy a futures contract that expires in May for $107.11 While the price of the June contract is $107.71. (Closing prices on April 13, 2011).
If the ETF buys the May contract to get exposure to the price of oil, come expiration time of the contract, the ETF either has to take delivery of oil (which they are not set up to do) or sell the May contract before expiration and replace it by buying a futures contract with a later expiration date.
Continuing with our example , if the ETF decides to “roll” the May contract to June, they would sell at $107.11 and buy back at $107.71. The fund has lost 60 cents a contract just to maintain the same exposure. On an annualized basis that is a 6.7% erosion of assets.
Different ETF’s manage the “roll” in different ways, but there is no question that the contango premium can be an invisible vacuum cleaner quietly sucking money out investor portfolios, and making it difficult for the ETF to effectively track the price of the underlying commodity over longer periods of time. This is why Mr. Dicker is so vehemently opposed to them, and recommends stock based ETFs to get exposure to energy prices as an alternative.
So knowing all this, why would an investor ever choose such an investment vehicle for their portfolio? Why not just hold stock based ETF’s to get exposure to energy (or other commodity) prices as Mr. Dickers suggests?
The answer is that holding the stocks or industry ETF’s of companies that deal in these commodities is not without its own risk. Indeed in the video above Jeff Mack directly asks Mr. Dickers this question, and unfortunately Mr.Dickers completely ignores the question and replies with a filibuster.
A multinational energy or mining company is subject to political risks of asset seizure and nationalization from foreign governments. Indeed further unrest and regime change (to forces not friendly to the west) in the Middle East could lead to a stock market decline in general and oil producers in particular would likely take a beating. At the same time the price of oil itself would likely soar. In such cases the energy futures based ETF would likely soar and the energy stock ETF would likely plummet.
Last summer when BP had its deepwater oil spill disaster in the Gulf of Mexico, it wasn’t long before some were beginning to speculate that the financial liabilities associated with the spill could potentially bankrupt the company. The price of oil may fluctuate wildly, but it is not going to go to zero. (It should be noted that while extremely unlikely , there could of course be a failure in the futures market, and there is a risk in holding the paper (futures) instead of the actual commodity)
In addition even if a company produces a commodity that is rising in price, it must itself deal with rising input prices in energy, labor and materials to remain profitable.
In his commentary Mr. Dickers notes that with the exception of the brief run up in 2008, that the Oil Stock ETF’s have had a near perfect correlation with the price of oil. This has been true in recent years in the big picture, but the exception of the “brief “ run up in 2008,is no small matter. This was the run that saw oil peak at $148 a barrel. It is exactly this type of “run” on a physical commodity that many investors (particularly investors who follow the Austrian School of Economics) are looking to gain exposure to.
Indeed correlation between oil stocks and oil futures has appeared to lessen over the last couple of months as well. In Dicker’s defense while the headline implies all energy ETF’s, Dicker himself emphasized two energy ETF’s in particular that do suffer from the worst of commodity based ETF’s shortcomings. (these being USO and UNG).
While the energy stock ETFs have outperformed the futures ETFs over the last several years, the case is not as clear-cut when it comes to Agriculture and Materials stocks. See a comparison: Selected Commodity ETF performance 03 31 2011.
There is no question that futures based ETF’s have flaws and investors should be careful about how they are used. But they do serve a purpose and if used in the right allocation for the right investor , they can be a valuable tool or hedge in protecting the overall purchasing power of a portfolio. The BIA Core Wealth Allocation Model Portfolio has in the past used both futures based and stock based ETFs to gain exposure to desired commodity markets.
In what appears to be an age of infinite fiat, investors will have to use a number of tactics and tools to stay ahead of the curve, and something that doesn’t look to appealing today, can quickly become tomorrow’s shining star...or bubble.
DISCLAIMER: Nothing in this article should be construed as a personal recommendation or advice. Nor should anything in this article be construed as an offer, or a solicitation of an offer, to sell or buy any investment security. Please consult a professional investment advisor before making any investment decisions.
As of April 14, 2011 Barnhart Investment Advisory Model Portfolios, client portfolios and principal held positions in the following ETFs mentioned in this article and related performance summary: XLE, DBE, MOO,DBA, XLB, DBB, GLD and SLV. Positions are subject to change without notice.