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By Scott Burns | 03-09-2011 02:05 PM

Think Oil Prices Are Going to Skyrocket? Try This ETF

An equity-linked ETF, versus products that hold futures contracts, will give investors more bang for their buck in a rising oil-price environment, say Morningstar's Scott Burns and Abraham Bailin.

Securities mentioned in this video
IEZ iShares US Oil Equipment&Services

Scott Burns: Riding the oil wave with equity-linked exchange-traded funds. Hi there, I'm Scott Burns, Morningstar's director of ETF research. Joining me today is analyst Abraham Bailin. Abe you are our expert on commodity ETFs, whether they are equity-linked or futures-holding. Thanks for joining me today.

Let's talk about how to capitalize on the rising momentum in oil prices through ETFs that don't actually hold the commodities directly but hold equities in firms that are very leveraged to what's happening there.

So when we look at the oil prices what's been happening right now with the equity-linked oil and gas ETFs?

Abraham Bailin: With equity-based oil funds--oil ETFs--you are going to get quite a bit of leverage that you are not going to get with futures, and the reason for that is operational leverage. So the firms that these ETFs are holding really exhibit a higher sensitivity to the underlying commodity price than say a direct holding of the spot commodity would.

Burns: So we see that oil prices go up $20, whatever the percentage of that growth, we see percentage of growth plus-plus for these equity-linked companies.

Now you've got operating leverage. Leverage is a funny thing; it cuts both ways. When things are going your way leverage is great, you want that, when things aren't going your way, it's not so great.

When we turn back the clock two years and oil went from $130 to $30, how do these funds hold up? How did they perform?

Bailin: Not too well, and the reason is quite intuitive. When the services of the firms underlying these equity-based ETFs were no longer in high demand, there was really little value in their holdings. And so if you wanted exposure to say spot oil, your best alternative at that point may have been to look to a dynamically based futures fund. But under the guise of rising oil prices, that leverage can really pay off.

Burns: Right, because then I think what happens is when you get on the downside, operating leverage obviously is harmful. But then you get the other leverage, financial leverage, at these firms that starts to kick in. So something for investors to be aware of, leverage cuts both ways. But, for an investor right now with a very high conviction that oil prices are going to continue to rise, what's your pick right now between equity-linked or futures-linked? Which way are we leaning right now?

Bailin: Well, you know really since the bottom after that downturn, late '08 early '09, we have seen the equity-based, not the futures-based, but the equity-based oil funds really outperform and track closer to spot much better than futures-based funds did. Within that space, probably our top pick would be IEZ, and that's going to be the iShares Dow Jones U.S. Oil Equipment Index

Burns: So the companies inside of this, these are oil-services companies. What is really the makeup of this portfolio?

Bailin: So, just like you said, the firms within this fund are going to be oil- and gas-services firms. So as oil prices run up and new projects start to come on line, you are going to see the demand for the services of these services firms really ramp up.

Burns: So it sounds like for those with strong conviction--as long as you know what you own, if things back off then it's going to hurt maybe a little more than if you held futures-based ETFs--equity-linked energy ETFs are a way to go right now from our perspective, is that correct?

Bailin: We'd say so, but again it's investment-thesis-dependent. At these elevated oil prices, it's a bit tough to make that call; are we going to $200 oil? Although that's a bit of a stretch, people may be looking for a downturn.

Burns: My Swami says call oil goes to $150 but not higher. But if oil gets over $150, then the economy goes back in the tank. What do you think?

Bailin: Well, it's quite possible, but on the way up, IEZ would be a great holding to have.

Burns: All right, Abe, thanks for joining me and thank you for joining us. I am Scott Burns, Morningstar's director of ETF research. For this and other ETF information please check out Morningstar.com's ETF center and Morningstar's ETFinvestor newsletter.

 

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