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By Jeremy Glaser | 06-07-2010 04:56 PM

Energy ETFs Don't Eliminate Deepwater Drilling Risk

Morningstar's Paul Justice sees the issues facing BP as being industrywide and that investors should look at smaller oil explorers and natural gas plays instead of buying a basket of oil majors.

Jeremy Glaser: Do energy ETFs mitigate risk? I am Jeremy Glaser with Morningstar.com.

With more investors looking to the ETF structure as a way to invest in the energy industry in light of the BP oil spill, does it actually make sense?

I'm here with Paul Justice, Director of ETF Research to discuss this. Paul, thanks for joining me today.

Paul Justice: My pleasure.

Glaser: So, does buying the basket of oil exploration stocks help eliminate some of the risk that you have from, say, another oil spill like the one that BP is experiencing right now?

Justice: Well, I think investors have a bigger-picture view. As a stock replacement vehicle, ETFs do make a lot of sense. But in this particular case, this is a risk that isn't isolated to BP. This is spread across the industry. Many of the largest ETFs that focus on the energy sector right now don't even own BP. It's not a primary listing in the United States stocks.

So if you look at, say, the Energy Select SPDR, probably the biggest energy sector from that you could buy, the ticker is XLE, that fund was down nearly 13% in May. This is a risk that really applied to most of the large major oil exploration companies because those are the firms that are involved in kind of deepwater offshore drilling.

So, just by missing BP, you still got hurt. So I wouldn't say that it eliminates all the risks, especially if they are systemic.

Glaser: A lot of investors see volatility as an avenue for opportunity. Is that the case now?

Justice: Well, I'm sure in hindsight it eventually will be, but I think that it's rife with risk right now. There are many moving parts: one we don't know what the total liability is going to be for BP. And once we do assess that, you have to think how going forward the integrated majors are going to address that cost because now you're going to have to look at some form of safety cost that you're going to have to implement for any new wells if they are allowed to go forward with those, and then, likely, self insurance, with ExxonMobil, how could you possibly insure that? It's bigger than any insurance company on the planet.

So, you're looking at very large potential risks from any individual well. Deepwater technologies, really, it's only about a decade old, and we're now seeing that, okay, so one problem can happen in a decade, why not see two or three, and if you start addressing that there's potential liability issues ranging from $10 to $100 billion around this, it's a tremendous increase to the cost structure. So I would be treading carefully if I'm going into something that has broad exposure to the deepwater.

Glaser: Is the general furor surrounding BP's handling of the spill going to lead to tighter regulation that could be a problem for the rest of the industry and could impact everything in an ETF holding?

Justice: It could impact a large majority of the holdings. That's something I would be worried about, because this would just be a simple lockstep increase in costs, and costs are going to get passed through to consumers and increased prices, but generally if you're going to increase price of oil say, 20%, then you're going to have demand destruction, it's not going to be very good. Of course, there's going to be relative winners within the space.

We've seen a lot of rhetoric coming out of Washington talking about the glory of natural gas. So, again, we're talking about shale gas plays, so that may be a potential opportunity there or some of the oil sands plays and more onshore oil, but we're still talking about things that have a higher cost structure getting out of the ground in the first place.

Glaser: If investors are dead-set on investing in the energy sector right now. What are some of their options and what do you think is the best ETF to do so?

Justice: Well, I think I would be looking still at the more heavy in natural gas. If you want to go through the First Trust ISE-Revere Natural Gas Fund, that's a good way to go. We also like the iShares Dow Jones, U.S. Oil and Gas Exploration, and really that's going to have a focus that's very heavy natural gas and oil as well, but you're going to be looking at some of the smaller players, people that didn't have a lot of the capabilities to go into the deepwater wells anyway. So I think that you're going to pick-up some decent exposure going that route in order to... whatever benefits there are from the fallout, a lot of those company should take part.

Glaser: Great. Paul thanks for joining me today.

Justice: My pleasure.

Glaser: For Morningstar.com, I'm Jeremy Glaser.

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