Oil ETFs: What You Should Know Before You Invest

What Are Oil ETFs?

An oil ETF is an exchange-traded fund (ETF) that offers investors exposure to the oil industry or oil as a commodity. The former hold equities in companies that operate across the fossil fuel industry. Commodity ETFs invest in oil futures or natural gas futures. They have different risk and return characteristics than equity oil ETFs.

In this article, we focus on fossil fuel industry ETFs, or alternatively oil ETFs. We briefly discuss commodity oil ETFs in this note. In a companion article, we discuss commodity oil ETFs in more detail.

In this note, we focus on traditional ETFs that are open-end funds organized under the Investment Act of 1940. They are largely limited to holding stocks and bonds. They are pass-through structures, where the income and capital gains flow through to investors; they are not taxed at the fund level.[1]

Types of Oil ETFs

There are some 55 ETFs covering the energy sector, plus several more focusing on oil and gas futures (Table 1). See Appendix A for a more detailed summary.

Table 1: Energy ETF Summary Type#Mkt Cap $MnShare Global42,271.62.7% U.S. Energy1354,878.165.8% Equipment/Services810,254.012.3% Oil Futures12,300.02.8% Natural Gas Futures2632.50.8% U.S. MLPs189,147.811.0% Levered123,909.14.7% 83,393.1

Source: Macro Hive, ETF.com

Global – These ETFs hold energy and equipment/services companies across a wide range of countries.

US Energy – These ETFs typically hold a broad range of US and Canadian energy companies, including exploration and production (downstream), pipelines and storage (midstream) and refining/marketing (upstream), although some are more narrowly focused on certain subsectors such as downstream or refining.

Equipment/Services – Companies held by these ETFs provide equipment and services to energy companies.

Oil and Natural Gas Futures – Exchange-traded products (ETPs) that invest in oil and natural gas futures.

US MLPs – Master limited partnerships (MLP) are special investment vehicles for commodities that offer certain tax benefits. They are mostly midstream energy companies where the business model is collecting fees and tolls, which are not dependent on the price of oil or gas. They appeal to investors looking for steady tax-deferred income. See Appendix B for more information.

Levered ETFs – Levered ETF products offer returns that are multiples (or inverses) of market returns. They may appeal to investors with strong views, but they also come with non-energy related risks. We strongly advise investors do due diligence before buying these products. We summarize these products in Appendix A for interested investors but do not discuss them further in this note.

Is This a Good Time to Invest in Gas and Oil ETFs?

We think it is. We are overweight the energy sector because it is cheap relative to trailing and forecast earnings and to cashflow generation.

The dividend yield of XLE (an ETF that holds companies in the energy sector of the S&P 500) is triple that of the S&P 500 – historically they have been similar (Chart 1). The arguably more important measure – free cash flow yield – is double that of the SPX – historically XLE FCF yield has been close to zero due to high CAPEX. The XLE price/earnings ratio is about 40% of the SPX; historically it has been near 80%.

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Further, most companies have signalled they do not plan to increase exploration and production CAPEX as they have previously when oil prices were near present levels. Their focus now is on generating and returning cash to investors. Indeed, the global rig count remains severely depressed even though the Russian invasion of Ukraine sent oil and gas prices soaring (Chart 2).

Energy ETF Performance

Over the past several years, energy ETFs significantly lagged the S&P 500 and oil and gas prices (Chart 3). They lost ground before the pandemic started due to depressed oil and gas prices and were further hit hard during the March 2020 selloff. But since then US energy and equipment/services ETFs have roughly followed the price of oil (Chart 4). Global and MLP ETFs have lagged.

Master Limited partner (MLP) products are a special form of ETF in the commodity sector. Qualifying funds are organized as limited partnerships that provide tax-deferred returns. They are popular with income-oriented investors. Hence most MLPs focus on midstream companies where the business model is collecting tolls and fees that are less sensitive to oil prices and will benefit little from the gusher of cash many energy companies will return to investors in coming years. We discuss MLPs in more detail in Appendix B.

The takeaway here is that if oil (or gas) prices fall sharply, many of these ETFs will likely also fall. But if most of these companies stick to their commitment to return cash to investors, that should cushion price declines. Whatever happens with prices, total returns from the return of cash will be the key determinant of investment performance.

The Best Gas and Oil ETFs

Focusing now on ETFs in the US energy and equipment/services sectors, ETF performance falls into two clear tiers (Charts 5 and 6).

The reason is that ETFs in the lower-tier group in both cases focus exclusively on companies involved in exploration and production – where there is little new CAPEX flowing into the sector. The winners hold companies active across the energy spectrum. Further, over the past two years performance within each tier is very similar. We summarize winners and losers in Table 2.

Table 2: Breakdown of High and Poor Performing ETFs

US Energy ETFs Equipment/Services ETFs Winners Losers Winners Losers FENY USAI FCG IEZ FTXN EINC IEO OIH FXN PXE PXJ IYE XOP XES JHME PSCE PXI RYE VDE XLE

Source: Macro Hive, ETF.com

Opportunities and Risks of Gas and Oil Investments in 2022

We think geopolitics all but ensures oil and gas prices will remain high versus the pre-pandemic period. We expect oil to trade near $100/barrel for the foreseeable future. We see little chance that it will fall to $60/barrel or less.

Our preference is to hold ETFs that offer broad exposure to the energy sector and the return of cash that will come to buy-and-hold investors. We suggest the XLE or VDE ETFs. Both offer low expense ratios of 10bp and distribution yields similar to many MLP ETFs (albeit without potential tax benefits).

  • XLE is by far the largest and most liquid energy sector ETF, with $38.8bn of assets under management. It holds companies in the energy sector of the S&P 500, weighted by market cap. Three companies account for more than one-half of the assets under management – Exxon Mobil (XOM), Chevron (CVX) and ConocoPhillips (COP) – so performance will be skewed if one of these companies does exceptionally well or poorly.
  • VDE, with $8.2bn of assets under management, VDE is the second-largest energy ETF. It holds energy companies in the MSCI US Index and caps the maximum allowable exposure to subsectors and companies, so it is more diversified than XLE.

Most of the other ETFs employ some form of active management and have expense ratios in the 30-60bp range. Investors interested in exploring these products can find more information at www.etf.com.

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Within the equipment/services subsector, we favour XOP. It is an equally weighted ETF that based on the energy sector of the S&P Total Market Index.

Any of the ‘winner’ ETFs in Table 2 are potentially attractive. They offer differing active management strategies and most carry higher expense ratios. The past year saw little differentiation across these ETFs.

Investing in Crude Oil and Gas Futures via ETFs

Investors can also get exposure to oil and gas indirectly via ETFs that invest in oil and natural gas futures. The primary oil ETF is USO; the natural gas ETFs are USNG and GAZ.

These ETFs hold futures contracts across a range of months. To the extent that the futures curve is not flat, there will be tracking error between the ETFs and spot prices.

The investment characteristics of these products are quite different from the fossil fuel industry ETFs discussed above. Their returns depend on oil and gas prices. They do not offer the upside from return of cash that many energy ETFs do. We discuss oil commodity ETFs in more detail in a companion note.

FAQs

How to invest in oil ETFs?

First, identify the type of oil ETF that suits your needs. There are 55 ETFs covering the US gas and oil sector. They range from funds that invest in equipment and services through to those which invest in gas and oil futures. You should research which type of fund meets your risk appetite and investment objectives.

How to buy oil ETFs?

Oil ETFs are traded on exchanges, so you can buy them on most trading platforms. Investors should research the charges associated with different kinds of ETFs and choose those which match their investment objectives.

What is the USO ETF?

The USO ETF is the United States Oil Fund LP. It is an exchange-traded fund structured as a commodity pool. It attempts to track the price of West Texas Intermediate Light Sweet Crude Oil.

What is a crude oil ETF?

It is an exchange-traded fund, or basket of securities, that tracks the price of crude oil as a commodity or contains crude oil stocks. It offers investors easy exposure to a commodity that is hard to directly own and store.

Appendix A: Gas and Oil ETFs

Appendix B: Taxes and Oil ETFs – Master Limited Partnerships

In this section, we briefly discuss some of the tax issues with master limited partnerships (MLPs) and exchange-traded products (ETP) that hold MLPs. Our purpose is to inform investors of the opportunities and risks of this sector so they can decide whether to pursue these products further.

The US tax code allows qualifying energy and natural resource companies to be organized as partnerships. A general partner runs the company, and investors are limited partners. The partnership does not pay taxes; tax consequences flow through to the partners.

Investors can defer taxes on distributions by effectively treating it as a return of capital and writing down the cost basis of their investment. When the sell their interest or when the cost basis reaches zero, they become subject to taxes.

Most investors in MLPs seek a combination of steady income and tax deferral. In the energy sector, the vast majority of MLPs are in the so-called midstream segment, which includes companies in the oil and gas transportation and storage sector. These companies typically earn fees or tolls and are only loosely tied to commodity prices (hence their steady income flows).

One disadvantage of MLPs for some investors is that filing tax returns can be complicated. US MLPs provide a K-1 form describing distributions and any related tax information.

The ETF industry has come up with several products to hold MLPs that are more administratively friendly, but they lack the tax efficiency of outright MLP holdings.

Registered Investment Corporations (RIC)

An ETF organized as a Registered Investment Corporation (RIC)-compliant 1940 Act mutual fund (as most are) can hold up to 25% of its portfolio in MLPs. This can contribute to higher and more steady income, but the investor misses the tax benefits of the MLP distribution.

C Corporations

Second, some ETPs have been structured as C corporations. They can hold MLPs; however, these ETPS are subject to double taxation. Income to the C corporation is taxed at the corporate tax rate and again at the investor level, resulting in double taxation similar to corporate dividends. To the extent the distribution is a return of capital, the investor can gain the tax deferral benefit of an MLP. That benefit does not extend to C corporation ETFs held in an IRA – in that case, all distributions are taxed as ordinary income when they are withdrawn from the IRA. C company ETPs where distributions are primarily return of capital may be more attractive to investors looking for tax-deferred income.

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Exchange-Traded Notes (ETN)

Another structure is an exchange-traded note, or ETN. This is a structured note issued by a bank that commits to pay the returns on a portfolio of MPLs. The distribution is treated and taxed as income even if is technically a return of capital. But it is not subject to double taxation. The risk is that the ETN is an unsecured liability of the issuing bank; if the bank goes bankrupt or otherwise defaults on the obligation, the investor loses money. ETNs may be more attractive if the underlying MLPs distribute mostly income rather than returns of capital.

Our goal here is to give an overview of ETPs that provide a means to invest in MLPs. It is not intended to be tax or investment advice. Investors who are interested in MLP-related products need to carefully evaluate prospective investments to ensure that the income and tax issues are compatible with their investment objectives.

More information is available here and here.

[1] The term ‘ETF’ is also used generically used to describe securities that trade on stock exchanges where investment performance depends on some underlying. It could be a portfolio of equities that meet some defined criteria, such as companies in the energy sector of the S&P 500; or the price of gold; or oil futures. Under this umbrella there a variety of different legal structures which have differing risk and tax features. More information is available here and here.

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First, identify the type of oil ETF that suits your needs. There are 55 ETFs covering the US gas and oil sector. They range from funds that invest in equipment and services through to those which invest in gas and oil futures. You should research which type of fund meets your risk appetite and investment objectives.

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It is an exchange-traded fund, or basket of securities, that tracks the price of crude oil as a commodity or contains crude oil stocks. It offers investors easy exposure to a commodity that is hard to directly own and store.

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Over a 30-year career as a sell side analyst, John covered the structured finance and credit markets before serving as a corporate market strategist. In recent years, he has moved into a global strategist role.
(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)
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