With the Middle East in turmoil and crude prices rising, many ETF investors are taking a second look at their energy allocations. But given the current state of affairs, do oil futures or equities make more sense?
Unrest in the Middle East usually means supply-side problems for oil, and the current month-long conflict raging in Libya is no exception.
Although Libya is only the 17th-largest oil-producing country in the world, the country remains an important supply hub, as it holds Africa's largest crude reserves. As a net exporter of oil, Libya sold around 1.3 million barrels per day (bpd) globally last year, and as recently as January, it produced 1.59 million bpd for domestic use and export. What's more, Libya exported approximately 100,000 barrels per day of refined oil products to OECD countries—mostly in Europe. Indeed, Austria, Ireland and Italy all receive over 20 percent of their imported oil from Libya.
As fighting continues in Libya, however, the International Energy Agency predicts the country's exports will remain nonexistent for many months. Foreign companies have long since pulled their staff from the country, and the chairman of Libya's National Oil Co. said production has fallen to less than 400,000 barrels a day as a result. Lawrence Eagles, head of commodities research at J.P. Morgan, said, "Our operating assumption is that there will be very little Libyan oil exported in 2011."
While Saudi Arabia has somewhat filled the production gap, don't expect OPEC as a whole to step in and increase its quotas, for it has stated several times that plenty of supply already exists in the market. Qatar's deputy prime minister and former oil minister noted, "The disappearance of the Libyan production hasn't really affected supply and demand, because we see compensation from other sources. When I look to the inventory, I see that the inventory is very high, over 60 days."
Ripple Effect Across Equities, Futures
As history has taught us, nothing in the oil market is an isolated event—especially when it's happening in the Middle East. And given the tight correlation between WTI and Brent crudes lately—over the past 40 trading days, the two have shown a daily correlation of 0.93—many investors are looking to oil markets closer to home to play events overseas.
To invest in WTI crude, ETF investors have two main options: futures, and equities funds. Let's look at each in turn.
As proxies to the oil futures market, I've chosen USO and USL; both ETFs hold futures contracts, though with different strategies. USO holds front-month oil contracts, rolling to the next contract each month as the current one expires. Obviously, this strategy has its pros and cons; USO is left exposed to some of the harshest effects of contango, but it can also benefit from front-month backwardation.
USL, on the other hand, spreads its holdings out over the next 12 months' worth of contracts. This strategy mitigates the negative effects of a front-month roll during times of contango, but it also dampens any benefit from backwardation as well. (See HAI: The Contango Report for the latest contango curves.)
For equities ETFs, I've chosen three SPDR funds ETFs: the Energy Select Sector SPDR Fund (NYSE Arca: XLE), the SPDR S&P Oil & Gas Equipment & Services ETF (NYSE Arca: XES) and the SPDR S&P Oil & Gas Exploration & Production ETF (NYSE Arca: XOP). All three ETFs track U.S.-traded oil and gas companies, although each concentrates its holdings differently:
