This report was prepared for use by advisors as a source of recommendations and a tool to effectively communicate with clients the many methods available to invest in oil. I have advised oil and gas executives for 28 years and our team has over 100 years of collective experience in energy. I hope you find this report useful in your daily practice.
I have addressed each structure beginning with the more straight forward structure (ETF’s) to the more sophisticated structure of Direct Investing which offers the greatest overall benefits to investors. ETF’s are a simple and passive way of gaining oil exposure. MLP’s generate good yield and are a moderately hedged way to play oil. Royalties provide excellent tax-advantaged yield, are a more direct play on oil prices which can create good opportunities for capital gains. Lastly, Direct Investing gives investors significant tax write-offs against their income, tax advantage cash flow, direct exposure to oil prices and the most upside potential of all the structures. There is no right or wrong way to invest in oil, but there are many circumstances which make one method superior to another depending upon the client’s needs.
Oil ETF’s are not created equal – but they all can have a place in a portfolio depending upon the client’s objective. We focus on 4 basic types of oil ETF’s: Oil Price, Upstream, Downstream and Oil Field Services (OFS).
OIL PRICE ETF’s
Oil price ETF’s own paper contracts, not physical oil or shares in energy companies and therefore have no long-term place in a client’s asset allocation and should only be used for short-term trading opportunities. Oil price ETF’s can vary widely from USO, which uses very short-dated futures contracts, to DBO which invests in much longer dated contracts. The shorter the contract, the higher the volatility and potential for large daily price swings. Depending upon your goal, each ETF (or a combination of the two) can be useful if used properly and in moderation.
Recommendations & Explanations:
USO: Even though USO has been maligned by the press for its dramatic 84%+ fall in less than 4 months earlier this year, it did what it was designed to do-which is track West Texas Intermediary (WTI) in a normal WTI price environment. However, when the markets swiftly dislocated, USO was unable to effectively track WTI physical price movement and traded at a steep discount to physical oil. Investors need to be aware this can occur with any oil price ETF that invests in short dated futures contracts. USO is the largest and most liquid oil price ETF, which is important when violent price swings occur, but the size and liquidity of the fund will not protect investors from harsh price movements. Just be aware of the underlying risks when markets turn ugly. With that said, the pendulum swings both ways and can be an excellent way to invest in the price movement of oil if you believe in oil’s recovery.
DBO: Flying under the radar is DBO. The underlying objective of DBO does not differ much from that of USO – it is the underlying investments that are very different. DBO invests in longer-dated futures contracts which results in much lower volatility and smaller price swings. While both USO and DBO have fallen precipitously this year, DBO has held up relative to its peer, with a 51% loss versus USO’s 84% decline.
USO and DBO are similar in that they are both ETFs and they both hold WTI futures contracts, but that’s about where it ends. DBO uses an optimization process in selecting which futures contract to own. This process involves a cost-effectiveness calculation on DBO’s part. Before its futures contracts roll over, the fund determines which futures contract has the best economics for the investor. At the end of the day, DBO uses a more proactive and analytical process for determining which contracts they should invest.
USO/DBO: One strategy to consider employing is a blend of both ETF’s which allows more flexibility in trading and taking profits on big “up” days using USO, while remaining in DBO for longer-term exposure to oil price recovery. A suggested split would be 80/20 in favor of DBO.
BOTTOM LINE: In normal times, oil price ETF’s will move closely with changes in WTI – and if used properly will provide clients with a tool to track the directional price of WTI. The question is how much volatility can your client handle? As seen in the following chart, DBO is much less volatile and sensitive to daily price movements than USO, but if you believe in the recovery in oil prices, USO will react much faster. (See Chart).
There are too many ETF’s to count and very few standouts to mention, however there are a select few standouts that do deserve attention which we have broken into 3 categories below:
- Upstream (Exploration & Production)
- Downstream (Refineries) ▪ Oil Field Services (OFS)
Here, the question comes down to bullishness. Upstream exploration and production (E&P) companies are going to see the greatest risk/reward from any uptick in oil prices, whereas midstream transport companies or downstream refiners will provide a more hedged bet. On the E&P side of the spectrum, energy companies are price takers, depending wholly on the price of oil — and they’re leveraged as well — which means their shares enjoy outsized gains when prices are rising, and steep declines when the opposite happens.
Recommendations & Explanations:
PXE: The Invesco Dynamic Energy Exploration & Production ETF is the purest play on E&P companies. Unlike many ETF’s that claim to be E&P focused, PXE is a invests in mostly upstream companies. It is a smaller ETF that gives investors exposure to 30 US E&P companies. While many sector funds simply assign weights to each stock based on their relative size (e.g., the largest stocks account for the largest percentages of the fund’s assets), PXE does things a little differently. For one, its underlying index evaluates companies based on various criteria, including value, quality, earnings momentum, and price momentum. It also “tiers” market capitalization groups, ultimately giving mid- and small-cap stocks a chance to shine. Roughly half of PXE’s assets are allocated to small companies, and another 36% are in midsize firms, leaving just 14% to larger corporations. Perfect for investors who prefer a more tactical research driven approach.
Refineries are ugly, dirty and typically boring. However, they can be a great way to play an oil recovery because they are not as directly tied to oil prices. The oil glut we are reading about eventually needs to be refined and refineries will stay busy. Refineries are buyers of oil from the producers, so when oil prices drop, they can sometimes get a boost from the lower prices since their cost of raw materials (oil) has dropped. As with any business, there are other factors that will drive profitability, but the largest driver is the price (cost) of oil.
Recommendations & Explanations:
CRAK: The VanEck Vectors Oil Refineries ETF tracks the performance of refiners, has a relatively low expense ratio of approx. .59% and is the purest play on refineries available to investors. Refineries are overlooked because they are not “sexy”, but they can be a great addition to a portfolio and used as a hedge against the volatility in oil prices. Consider using CRAK as part of your overall allocation to oil by allocating 15% -25% of your total energy allocation to refineries to smooth returns. As a bonus, the portfolio kicks off a yield of approximately 2%.
OFS ETF’s (Services)
OFS stocks are highly correlated to oil prices and these companies are at the mercy of the capital budgets of the producers – and for this reason and others, the services sector is tough. Cap-ex budgets were already under pressure in 2019 and now with oil prices where they are now, budgets are getting slashed for 2020 and likely in 2021. Producers cannot control the price of oil, but they certainly can try to control what they pay for services, and right now they don’t want to pay much. It is worthwhile keeping a pulse on OFS ETF’s as they are typically the first sector to turn around as oil prices rebound and producers begin to spend money again. Until then, pricing pressure will be an overhang for service providers and OFS ETF’s.
Recommendations & Explanations:
OIH: There are approx. 4 services ETF’s – and they all perform almost identically. Their strategies are similar, and expenses are within basis points. With that said, we recommend OIH because it is the largest, most liquid, and slightly outperforms its peers.
Appropriate for investors seeking both yield and total return with less volatility than more direct oil exposure. MLP’ have historically been a safer way to play a recovery in oil prices because they are not a direct investment into oil. However, since MLP’s are in the business of transporting oil and gas through vast networks of pipelines, they typically get “lumped in” with oil & gas companies and tend to rise in good oil environments and fall in bad. MLP’s get paid a fee for transporting oil and gas through their pipelines, yet they can still carry direct and indirect risks listed below. With all this said, we do not expect oil prices to remain subdued long enough to create any notable issues for the larger better capitalized MLP’s.
- Commodity Price Risk: Although the majority of MLP’s are mostly immune to commodity price volatility, they still tend to get “lumped in” to the oil category because they still carry some level of commodity risk. For example: Enterprise Products’ (EPD) revenue is approximately 86% fee based.
- Tenant Risk: MLP’s are mostly protected from commodity price swings, but their clients are not. Therefore, MLP’s could possibly need to restructure existing contracts, resulting in lower income. Some could even go into bankruptcy.
Recommendations & Explanations:
BMLP: The Dorsey Wright MLP Select ETF (symbol: BMLP) is different from most MLP ETF’s for several reasons:
- BMLP uses the long-proven Dorsey Wright methodology to actively manage the portfolio and add value in terms of both risk and return. Other MLP ETF’s attempt to “hug” the index and not get involved with active management.
- BMLP includes only the top 15 MLP’s they deem to be the best vs. the mammoth Alerian MLP fund (symbol: AMLP) which has 23 or more holdings and passive management.
Clients seeking yield and who desire income that rises (and falls) in sync with commodity prices, Royalties are a great play. Not only do they offer an exceptional yield, 15% of the income passes tax-free to the investor. Think of The Beverly Hillbillies and Jed Clampett. Jed found oil on his property, but never spent a dime to drill and complete a single well. Instead, for a perpetual stream of royalty payments he allowed others to spend their money to produce the oil – and he received a royalty check for every ounce of oil produced. There are three ways to invest in royalties:
Recommendations & Explanations:
- Publicly Trade Royalty Trusts (PRT’s)
While most publicly traded royalty trusts are not worth mentioning because their history of reserve replacements is poor or the reserves are short lived, there are several that should be considered. It should be noted that Sabine Royalty Trust (symbol: SBR) is the only pure play on oil and gas royalties because it contains no working interests. Below are 2 recommendations:
- SBR: Sabine Royalty Trust: Forward Yield 61% (as of 5/20/2020)
- PBT: Permian Basin Royalty Trust: Forward Yield 30% (as of 5/20/2020)
- Royalty MLP’s
Royalty MLP’s differ from PRT’s mentioned above because unlike PRT’s they actively manage and constantly aggregate minerals resulting in a constantly growing portfolio. It is for this reason Royalty MLP’s offer the greatest potential during low oil prices as it allows them to buy mineral rights cheaply from sellers. Below are 2 recommendations:
- KRP: Kimbell Royalty Partners: Forward Yield 81% (as of 5/20/2020) *
- BSM: Blackstone Minerals: Forward Yield82% (as of 5/20/2020) *
- VNOM: Viper Energy Partners: Forward Yield 81% (as of 5/20/2020) *
- Private Placement Royalties
For accredited investors, private royalty funds are a more favorable way to invest in royalties. Private placement funds can yield in the low to mid-teens, with 15% of the income passing tax free to investors. There are a few groups that specialize in royalties, but before investing be certain to do your homework to make sure the group you chose is aligned with the investor and structured with a fair and reasonable fee structure. If you want suggestions for private royalty funds, please feel free to reach out to me to discuss or send me an email.
DIRECT LP INVESTMENT
Tax write-offs, tax-advantaged cash flow and better upside potential.
Thanks to the Tax Cuts and Jobs Act signed in 2017, the already very favorable tax incentives for direct oil and gas investing are even more beneficial as an investor can write-off the tangible costs of wells through accelerated depreciation. This new tax incentive allows in many circumstances for 100% of an investment to offset AGI in the year the investment has been made. As an example, this means a properly structured direct investment of $200,000 could save your client between $65,000 – $80,000 in taxes on day one. This is an excellent way to add direct value to your clients. Direct investment funds can also yield in the low to mid-teens – with 15% of the income passing tax-free to investor.
Direct investments are the most favorable way to invest directly in oil and gas wells. Key to direct investing is conducting basic due diligence on the sponsor to answer the following questions:
- Does the sponsor have technical staff with strong operational backgrounds on their team?
- Are the sponsor incentives aligned with investor?
- Is the fund structured with fair and reasonable fee’s?
- Does the sponsor have “Skin in the Game”?
The qualifications of the sponsor’s staff are critical when conducting due diligence. Are they petroleum engineers, geologists, or land men with prior upstream operating experience? Or are most of their backgrounds in sales, marketing, and business development? Without question, you want to align yourself with sponsors who have strong technical teams and decades of oilfield experience as part of their company rather than a team comprised of sales and marketing.
Misalignment of incentives occurs when the sponsor is making a substantial portion of their promote up front before the well is drilled. It is critical that you can answer the question: How is the sponsor making money? Is it from the production of the well like the investor? Or is it upfront from fees before the well is drilled? Additionally, many funds have high fees due mainly to the fact that they are paying commissions to sales teams. You should ask the sponsor if there are upfront commissions being paid.
Lastly, does the sponsor invest their personal money directly alongside the investors? If the answer is “yes”, you can feel certain their interest in the success of the investment being perfectly aligned with that of the investor. If the answer is “no”, investors should be very cautious.
Bottom line: The tax benefits associated with direct investing offer a unique incentive for advisors’ clients and are an option that should be given consideration in the overall wealth management of advisor’s clients.
If you would like additional information on any of the methods listed above, please do not hesitate to email, call directly, or schedule a call via my Calendly link provided in my email. You can also access a Tax Guide on Direct Investing by visiting www.invitoep.com and clicking on the Advisor Access tab and registering for access – or you can email me back directly and request the Tax Guide
*Source: Yahoo! finance