Read this before you invest in energy ETFs

Investors who want exposure to the energy sector through commodities like oil and natural gas have several choices.

One way is to invest in ETFs that hold futures contracts, but there are several wrinkles you should be aware of first.

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Coming up short

The United States Oil fund (USO) is the largest ETF tied to oil prices, while United States Natural Gas ETF (UNG) is the largest that tracks natural gas prices.

It has been well documented, however, that while these ETFs do a good job of tracking prices over short periods of time, they have significantly underperformed the markets they are designed to track over longer periods.

For example, from December 31, 2010 to August 29, 2014, the prompt month crude oil futures contract rose from $91.38 to $95.96 per barrel for a 5 percent gain. Over the same period, USO declined 8.7 percent.

UNG is notoriously bad in this regard. From the end of 2010 through August 29, 2014, natural gas futures contract dropped from 4.405 to 4.065 per MMBTU, a 7.7 percent drop. UNG, however, fell 53.5 percent!

There are several reasons these ETFs have performed so poorly. These ETFs hold prompt month and near prompt month futures contracts, and before these contracts expire, they must be sold, and the proceeds reinvested in futures contracts that are further from expiration.

This is referred to as “rolling” the futures. The process the ETFs have developed for rolling futures contracts from one month to the next is very mechanistic and transparent to the wholesale trading community, which drives this underperformance.

There are other oil and natural gas ETFs which attempt to address some of these flaws, but most of them have low assets bases and are very illiquid, which limits their attractiveness to investors.

One alternative to owning commodity-focused ETFs that purchase crude oil or natural gas futures contracts is buying ETFs focused on companies in the oil and natural gas exploration and production sector. The companies in this sector directly benefit when the price of oil and natural gas go up, and at least in theory, changes in their stock prices should reflect changes in energy prices.

A better way

However, looking into this more deeply, the correlation between underlying wholesale energy prices and the valuation of E&P companies is not particularly strong (particularly for natural gas), and is secondary in importance to the overall strength of the broad stock market.

Over the 12 months ending August 2014, correlation between the daily price change of the prompt month crude oil futures contract and the SPDR S&P Oil & Gas Exploration and Production ETF (XOP) was slightly less than 40 percent.

The correlation between the daily price change of the prompt month natural gas futures contract and XOP was below 10 percent. In contrast, the correlation between XOP and the S&P 500 Index (SPX) was close to 65 percent over the same period of time.

Historically, these correlations have been stronger in the past, and this untethering of E&P valuation from oil and natural gas prices might only be temporary.

However, even if the correlation between E&P stocks and energy prices rebounds to more typical levels, much of what drives the valuation of stocks in the E&P sector is broad stock market. The value of using XOP and other E&P-focused ETFs as a vehicle to get exposure to oil and natural gas prices is very questionable.

Perhaps a better solution would be the creation of tenor-specific oil and natural gas ETFs. My suggestion would be to borrow an idea from the ETF provider Guggenheim Investments and their BulletShares Corporate Bond ETF series, and develop commodity ETFs that expire when their underlying futures holdings expire.

This would avoid the performance degradation that occurs from rolling futures, and allow oil and natural gas ETF investors to more carefully select and focus their exposure.

Photo credit: Greig Davidson via Flickr Creative Commons

DISCLAIMER: The investments discussed are held in client accounts as of August 31, 2014. These investments may or may not be currently held in client accounts. The reader should not assume that any investments identified were or will be profitable or that any investment recommendations or investment decisions we make in the future will be profitable. Past performance is no guarantee of future results.