Avoid a Potential Minefield in the Oil Patch

With a constant flow of headlines during the past several months, interest in the energy sector is gushing. In the first quarter of the year, investors have poured nearly $5 billion into exchange-traded funds in the equity energy Morningstar Category. Extending back six months, estimated net inflows approach the $10 billion mark. For some context, there are 24 ETFs in the category with combined assets of about $27 billion as of the end of March 2015.

The past two quarters have been the largest on record, in terms of net asset flows, by a wide margin. The timing suggests that investors are bottom-fishing after the collapse in crude-oil prices decimated the sector. Even

to take advantage of depressed prices, as it announced plans to acquire

Before following the crowd, investors would be well-served to survey the landscape of potential ETF options. In a recent article, I highlighted the structural risks associated with ETFs that use futures contracts to gain exposure to crude-oil itself. Within the equity energy category there are many unique offerings, each with its own risk profile.

Varying risks tend to be a function of a particular fund's weighting methodology and industry exposures. An ETF that leans toward integrated supermajors is likely to be less volatile than an ETF that concentrates in exploration and production firms. I touched on this in an earlier article about how oil services could be an attractive industry within the oil patch for risk-tolerant investors seeking investments with the highest sensitivity to changes in oil prices. Such precision is not always necessary. In many cases, going for the cheapest and most broadly diversified option is the way to go.

Broad and Cheap

As a market-cap-weighted fund, the portfolio is top-heavy. Vertically integrated supermajors

Other segments of the oil patch, such as exploration and production, are much more sensitive to volatile energy prices. Investors should expect the underlying firms' reliance on energy prices to translate into higher volatility for VDE relative to the broader market. For example, the S&P 500 experienced a standard deviation of returns of 15% over the trailing 10 years. During the same period, the standard deviation of returns for VDE was nearly 23%. Geopolitical risks can be a key factor driving volatile energy prices. Current turmoil in the Middle East, speculation about production cuts (or lack thereof) by Saudi Arabia and other OPEC members, as well as surging shale-oil volumes out of the United States have all contributed to recent energy price volatility.

Investors looking to take advantage of heightened volatility in the sector should find this fund to be an effective tool for overweighting the energy sector within a broadly diversified portfolio. The energy sector currently makes up about 8% of the S&P 500. Keep in mind that as a U.S. sector fund, VDE does not offer exposure to international supermajors such as

Fundamental View Integrated oil and gas companies have operations that span the full energy value chain. These companies, which represent a third of VDE's assets, explore for and produce oil and gas, transport it, refine or process it, and sell it to end users. The integrated model has historically provided firms like Exxon Mobil and Chevron with competitive advantages. By integrating across the energy value chain, these firms are able to gain much tighter control over the production and sale of oil and gas, and they get to keep profits they would otherwise have paid out to middlemen in the form of economic rents.

In an attempt to secure long-term access to large-scale resources, the large integrated firms are competing for huge new projects and increasingly partnering with foreign national oil companies seeking to exploit government-owned resources. In a world of diminishing investable resources, securing such partnerships is important to help drive growth. This puts added emphasis on a firm's technical expertise, ability to execute on time and budget, safety record, and cost of capital.

Exploration and production firms, which make up 30% of VDE's portfolio, concentrate their efforts almost exclusively on exploring for, acquiring, and producing oil and natural gas. These firms face myriad risks, including commodity price volatility, exploration risks, operational risks, and political and regulatory scrutiny. Given the intense competition in this segment as well as the difficulty individual firms face in establishing competitive advantages, getting diversified exposure through an ETF like VDE may be appropriate for most investors.

Remember, along with significant operating leverage, most exploration and production firms also operate with substantial financial leverage. So if oil prices continue to fall, or stay depressed for a considerable period, default risk becomes a critical consideration. Since getting an edge here is extremely difficult for the average retail investor, it makes a lot of sense to diversify with a fund like VDE rather than select individual exploration and production firms, some of which may not make it out of a bear-case scenario.

Equipment and services firms, which make up 16% of VDE's assets, provide the expertise necessary to improve oil and gas well economics and boost well productivity. The industry does serve U.S. independent oil and gas firms, but its largest customers tend to be the major international and government-owned oil companies. Demand for services in any given year tends to wax and wane, depending on expectations for commodity prices, particularly in North America, where contracts are usually very short.

The cyclical nature of the industry can obscure some of the positive long-term trends, which remain favorable. Oil is becoming harder to find and extract. Global oil production has been stagnant since 2005, even after a trillion-dollar investment by the oil and gas industry. The number (and size) of oil discoveries has been declining for decades. Oil-services firms' expertise is growing increasingly more valuable as the industry seeks to explore and extract oil from ever-more-challenging frontiers in new deep water and even the Arctic. Large efforts are also under way to boost recovery rates from old fields.

Morningstar equity analysts use benchmark oil and gas prices based on Nymex futures contracts in their discounted cash flow models. If those forecasts prove incorrect, then their fair value estimates will be off en masse. As of this writing, Morningstar equity analysts estimate that VDE is trading at a 5% discount to its aggregate fair value. For risk-averse investors, this may not be a large enough margin of safety, given the current geopolitical tensions and oversupply concerns plaguing the oil patch.

But for those with a positive long-term outlook for the sector and the ability to withstand continued volatility over the intermediate term, VDE is an excellent choice for diversified exposure to the energy sector. And remember, fair value estimates are dynamic. For instance, if the rebound in crude-oil prices that many energy bulls are expecting comes to fruition, the higher benchmark oil and gas prices will drive up fair value estimates. In such a scenario, extensive financial and operating leverage within the sector can lead to meaningful shifts in company valuations.

Portfolio Construction VDE is tethered to the MSCI US Investable Market Energy Index, a free-float, market-cap-weighted benchmark that focuses on firms involved in the U.S. energy sector, including those in exploration and production, oil service, natural gas, and coal. The fund, which holds about 160 companies, invests across the market-cap spectrum, but its smaller constituents are dominated by major U.S. oil firms. Exxon Mobil, the largest oil firm in the world, makes up about 22% of assets, and the top 10 holdings soak up about 62%. Overall, large-, mid-, and small-cap stocks represent 81%, 13%, and 6% of assets, respectively. The holdings-weighted average market capitalization of the fund's portfolio is about $56 billion.

Fees This ETF's 0.12% expense ratio makes it one of the cheapest energy funds around. The fund's estimated holding cost of 0.13% means that the fund has tracked its benchmark tightly and also was able to offset a portion of the expense ratio with proceeds from its share-lending program. Note, the difference between the fund's expense ratio and its estimated holding cost is typically explained by the transaction costs associated with employing an ETF's replication strategy.

Alternatives

Two close alternatives for exposure to the domestic energy sector are

For exposure to the international energy space, investors may also consider

Disclosure: Morningstar, Inc.'s Investment Management division licenses indexes to financial institutions as the tracking indexes for investable products, such as exchange-traded funds, sponsored by the financial institution. The license fee for such use is paid by the sponsoring financial institution based mainly on the total assets of the investable product. Please click here for a list of investable products that track or have tracked a Morningstar index. Neither Morningstar, Inc. nor its investment management division markets, sells, or makes any representations regarding the advisability of investing in any investable product that tracks a Morningstar index.