What’s the Best ETF for Playing an Oil Price Rebound?

A lot of investors seem very interested in bottom-fishing in the oil and energy realm these days. Perhaps that fact by itself ought to give everyone a little pause. It certainly does me!

The attraction, of course, is that oil's big crash from its June 2014 peak has made for a lot of "lower prices." Obviously, we all like to "buy low," when possible. Plus, almost everyone agrees oil isn't going away anytime soon. I don't dispute any of that.

On the contrary, as I've cited before (see my January 22nd blog, for example), the oil industry must find a bunch of new oil each year – about 5% of its current productive reserves – just to keep up with demand. About 4% of the 5% increase is required merely to replace depletion. The other 1% is to meet demand growth. Another way of stating the same thing is that by 2020, the industry will need to find about 30 million bbl/day of new oil supplies (compared to today's production of about 93 million barrels per day).

Furthermore, to reiterate a few more key points from that Jan. 21st blog, emerging countries are poised to continue increasing their demand for oil and energy as they expand the world's "2nd great industrial revolution." This is not a small deal or a short-term flash in the pan, as emerging countries are home to about 6 billion of the world's 7 billion people. In addition, the world's population is set to increase by 2 billion by 2040, and much of the increase will occur in emerging countries.

As another anecdotal piece of evidence, China's auto sales are projected to increase to around 31 million per year by 2020 (up from about 23 million per year today). India is 20 years behind China by some estimates, with another 1.3 billion people. U.S. auto sales, by comparison, are around 17 million. (source: Richard Hirayama, WHV International Equity Update, December 2014; see whv.com).

How to play an oil-price rebound

Assuming you're on the bandwagon and want to invest in the possibility of a V-shaped oil rebound (which I discussed in my January 30th blog), what's the best way to play it?

Several options exist. Today we'll look at oil ETFs. These ETFs are designed to simply track the price of oil. If you want to bet on a V-shaped recovery in oil prices, this is a pure play.

In future articles, we'll look at other investment options, including ETFs that invest in oil and energy stocks, if you'd rather get your exposure via the companies that make up the sector – or some sub-set of the industry.

Another future article will discuss yet a creative, non-ETF strategy for betting on an oil or energy sector recovery, while protecting against downside risk, using options to minimize the dollar amount placed at risk.

Oil ETFs

I've listed 3 of the largest, most liquid oil ETFs in the table below.

As you can see (in bold font), USO has outperformed OIL and DBO over the 1- and 3-year time frame (although USO’s margin of victory over DBO in the 3-year time frame is very slim). DBO, though, has outperformed over the last 5 years, annualized. (Of course, ALL of them have been clobbered, which is why so many people are interested in this opportunity to "buy low").

Turns out, DBO claims to have solved an inherent problem that allegedly weighs on the returns of the other 2 ETFs. Since all 3 funds use futures contracts as underlying investments, a technical futures trading phenomenon known as contango comes into play. Contango occurs when the nearest-month futures contract is priced lower than futures contracts for farther-out months. USO and OIL, though, ALWAYS invest in the nearest-month contract anyway; and as a result, they must (by definition) automatically roll into the next month's contract every 30 days or so – whether it's higher-priced or not. Therein lies the problem. If the next month's contract is priced higher than the contract USO or OIL currently owns (as frequently does occur), the fund will suffer some ill effects (known as decay) from the transaction. DBO, on the other hand, designed its fund to automatically roll into the most attractive near-month futures contract (of the next 13 months) – thereby, in theory, minimizing the negative impacts of contango.

The bottom line, in my interpretation, is that DBO truly may be just a little more efficient than the other ETFs. In a simple attempt to quantify whether that conclusion holds water, I looked at calendar-year returns for all 3 funds so I could get a sense for how each fund performs in a variety of different environments. Here's what I found:

As you can see, even though its expense ratio is slightly higher, DBO has outperformed both USO and OIL in every calendar year since 2008, except for some slight underperformance in 2014 and 2015 YTD.

I assume some (if not most) of DBO’s consistent outperformance can be attributed to its contango strategy. Whatever the reason, DBO would be my choice due to its consistent track record.

Tax considerations

I'm not qualified to give tax advice, which ought to be personalized anyway, so please consult your tax professional before investing in any of these funds. BUT INVESTING IN THESE FUNDS MAY AFFECT YOUR TAX SITUATION, SO PLEASE BE INFORMED.

Specifically, with both USO and DBO, expect the following – unless you're investing inside an IRA:


• Late tax forms (probably in March)
• Taxable amounts every year (even if you still own your shares!)
• Watch for adjustments to your original cost basis every year, based on total income, expenses, gains, losses, and distributions.


Allow me to attempt to explain.

USO and DBO both issue a K-1 each year, which potentially passes along a 60/40 blend of long-term and short-term capital gains to the investor. USO says on the tax page of its website that it strives to distribute K-1s in March. DBO's tax page – which includes a helpful sample K-1 – says PowerShares has historically sent its K-1s before March 1st.

OIL, for its part, sends a 1099 instead of a K-1.

With USO and DBO, you're technically a limited partner in a partnership. The fund doesn't file taxes, but rather passes everything – all income, losses, etc. – on to its limited partners. Therefore, you'll likely pay taxes every year you hold the fund.

If you invest inside an IRA, none of this should matter. USO and DBO both clearly state their funds do not expose investors to "unrelated business taxable income," or UBTI. I gather this is by virtue of USO being an investment fund rather than an active business operation, because otherwise, as with the energy MLPs with which I'm familiar, any UBTI a $1,000 annual threshold is taxable to IRAs. Again, USO and DBO are NOT subject to any UBTI rules or limits.

Timing

Many energy-stock ETFs now sport green MarketClub triangles for short-, intermediate-, and/or long-term plays. However, these 3 pure-play oil ETFs still (as of Wednesday, April 15th) show a red "monthly" (or long-term) triangle – signifying it may be too early to invest (at least, if you like to wait for technical confirmation before investing in an effort to reduce risk).

If, like me, you fear sentiment is too enthusiastic to make for ideal "V-shaped recovery" conditions, yet you want to have some exposure, you might consider one or more of these ideas:

• Consider buying half your position now, then wait for MarketClub's triangles and/or other indicators to confirm it's okay to add more.

• Start by buying energy MLPs, which are generally companies that own oil pipelines and are thereby somewhat insulated from oil price shocks. See my blogs from 12/16/2014 and 3/2/2015 for some ideas. There are a lot of relatively new ETFs in this space, too. I'll write about it sometime!

• Start by buying integrated oil majors like XOM, CVX, BP, RDS.A, COP, etc.


Watch for my next articles for other ideas. Expect the next one within a week.

Best,
Adam Feik
INO.com Contributor - Energies

Disclosure: At the time of post publication, this contributor owned Enterprise Product Partners (EDP), but did not own any other stock mentioned. This article is the opinion of the contributor themselves. The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. This contributor is not receiving compensation (other than from INO.com) for their opinion.