ETF Of The Week: Riding Crude's Rise

September 20, 2019

What is the best ETF play for commodity exposure?

It is a question we have gotten a lot over the years, and the truth is, for any given hard asset, there are compelling reasons to use either futures- or equities-based ETFs, depending on what you are trying to do (read: "Live Chat: ETF Tactical Tools & Finding Growth").

That said, to take advantage of short-term pops in underlying commodity prices, stock ETFs are often a better source of immediate return than futures-based ones (read: "Equity-Based Commodities: Better Than Futures?").

We are seeing that very situation play out now in the crude oil space. After last weekend's attack on Saudi Arabia oil reserves, in which drones knocked out 5% of the world's oil supply in one go, crude oil prices have skyrocketed.

In the days following the attack, Brent crude saw its highest-ever price spike, while WTI crude prices jumped from $54.84/barrel up to $62.90/barrel (though since they have come back down a bit).

However, futures-holding crude oil ETFs, such as the United States Oil Fund LP (USO), have only seen limited benefit. Over the past month, USO has risen 8%; not bad, but not nearly as good as the VanEck Vectors Oil Services ETF (OIH), which has risen 25%.

Equities Vs. Futures

In part, the reason USO and oil funds like it have lagged is that futures-based ETFs are just that: futures-based. They don't track the price of spot oil—which is what you see crawling across a CNBC ticker—but the expected future price of oil, as dictated by the price of some combination of derivatives contracts inside their portfolio.

To the extent that futures ETFs do reflect higher spot prices, usually it's only insofar as higher prices today usually mean higher prices tomorrow.

Contrast that to commodity equities, whose stock prices can—and do—jump on every twitch in the spot market of the underlying commodity. These companies' revenues depend on higher commodity prices, because the higher the price, the more lucrative it becomes to start or expand production activity.

As such, commodity equity ETFs behave as leveraged plays of the underlying commodity price: Companies rise when it looks like they will make more money off the stuff they pull out of the ground.

Why Oil Service Companies?

However, the crude oil market has an added twist on this.

Oil exploration companies, which make money based on how much oil they produce, don't usually own their own drills. To handle the actual drilling, they turn to stand-alone oilfield service companies, such as drillers and well servicers, which build and maintain the equipment that gets that black gold out of the ground.

These oil and gas service companies make money based on how long they are contracted by the exploration firm, not by how many barrels of oil they produce. As such, this sector can benefit from higher crude prices without having its profits directly tied to mercurial commodity pricing.

Of the four oil services ETFs, the best-performing is OIH, a fund that holds 25 of the largest U.S.-based oil services firms.

 

Source: StockCharts.com; data as of Sept. 19, 2019

 

At $720 million in assets, OIH is also the largest and oldest such fund in the space. It is also a liquidity stalwart, with more than $132 million in shares traded daily, on average, and the smallest spread (0.08%) in the space.

That said, OIH is not much good as a hedge for oil prices—which is a major reason investors hold commodity ETFs in the first place. In that case, futures-based ETFs like USO would be a much more appropriate choice.

Contact Lara Crigger at [email protected]

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