Bet on oil the right way - InvestingChannel

Bet on oil the right way

Energy is on fire.

Not literally, that would be dangerous.

We’re talking about energy stocks.

For those lucky enough to ride the trend, some have seen individual equities double in the last year.

Will energy continue to run?

It’s tough to say.

Regardless, we wanted to give you the blueprint to navigate this crude world.

Long-term, there’s a secular shift away from fossil fuels.

Yet, it will take multiple decades to completely move away.

In that time, there is plenty of money to be made.

If individual stock-picking is in your wheelhouse – all the more power to you.

But for most portfolio managers, using sector ETFs and funds work much better.

In the oil sector, there are three parts to understand.

Three parts to oil

The first stage in oil production is finding and drilling out the black gold.

Companies in this area are known as exploration and production or E&Ps.

They live and die by the price of crude oil. So, when crude oil heads higher, they make bank.

The SPDR S&P Oil & Gas Exploration ETF XOP is one of the most popular ways to play this sector.

With 68% exposure to E&P companies, it’s managed to climb +170% from the lows last March.

Next up are the midstream companies.

When you need to transport and store oil, they’re who you call.

You can think of them like toll roads.

Most are structured as Master Limited Partnerships or MLPs. 

MLPs are similar to REITs except that they target a specific dividend amount instead of a percentage of profits.

Warning: They also have different tax treatments!

Most pay high dividends.

Amongst MLP ETFs, Alerian’s MLP ETF AMLP trades over 2.5 million shares a day and pays a healthy +8% dividend.

Lastly, you have refining and marketing.

These are the companies that turn oil into gas and deliver it to the gas station (think Chevron).

Companies in the downstream operation make money in what’s known as the ‘crack spread.’ This is the difference between what oil costs compared to what they can sell it for including refining costs.

Generally speaking, these companies do better when oil is cheaper since they can buy raw materials for less.

Unfortunately, there aren’t any ETFs in this area that have good volume.

VanEck’s Oil Refiners ETF CRAK covers companies in this sector, but it only trades around 7,000 shares a day.

A better route is to go with the all-encompassing SPDR S&P Select Energy XLE.

It acts like an integrated oil company such as Exxon Mobil, with coverage of all three parts of the supply chain.

Our hot take

A significant amount of the S&P 500 includes energy companies as opposed to the Nasdaq 100.

Make sure you account for this if you look to include an energy ETF in your portfolio.

Questions from your clients

  • Can I buy Oil companies like BP that aren’t based in the U.S.?
  • Where does Saudi Arabia’s Aramco fit into things?
  • What factors influence the price of oil and gasoline?
  • Is there a significant risk with MLPs even though they pay high dividends?

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