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In preparing for an interview on Fox Business News regarding oil related Exchange-traded Funds (ETFs), I came across some interesting information on the current oil related products available that we thought appropriate to share.

Given the dramatic rise in the price of Oil this year alone, coupled with the recognition that oil remains the lubricant that turns the global economic machine, one would be hard pressed to find an advisor or individual investor who isn’t considering an oil oriented investment for their portfolios.  ETFs have provided these investors with several different types of opportunities to add exposure to the energy sector, and oil in particular.  However, as with other ETFs, the devil is in the details and investors need to conduct their due diligence and understand the structure of each available ETF before making an investment decision.

For example, as we at Hennion & Walsh see it, there are three different avenues in the ETF arena for oil related investment strategies:

1)      Futures Based Strategies – a couple of the more recognizable ETF products related to oil involve futures contracts on crude oil.  Two such ETFs are the United States Oil ETF (Ticker: USO) and PowerShares DB Oil ETF (Ticker:  DBO).  However, investments in these types of derivative instruments bring terms such as contango and backwardation into the equation.  Contango involves a scenario where future prices for a given commodity are higher than spot prices whereas backwardation involves a scenario where future prices for a given commodity are lower than spot prices.  These two scenarios can create an environment where performance expectations of investors may not be met due to the tracking error versus the underlying commodity index that is created.    As a result, for ETF strategies such as USO where the portfolio is constructed to buy the “near month” contract when necessary, periods of contango can lead to underperformance versus the underlying commodity index.  The PowerShares DB Oil ETF attempts to minimize the negative effects of contango by buying the contract month with the highest effective roll yield when necessary.  Both strategies will not perfectly track the crude oil spot index regardless.

2)      Oil & Gas Production & Development Company Strategies – as opposed to offering exposure directly to the oil market, these ETFs offer exposure to companies who operate in the oil sector, specifically related to oil & gas production and development.   Two such products available in the marketplace today are the iShares Dow Jones U.S. Oil & Gas Exploration ETF (Ticker: IEO) and the SPDR S&P Oil & Gas Exploration & Production ETF (Ticker: XOP).  To give you a feel for some of the companies associated with this sector, here are the Top 5 holdings of each ETF according to Morningstar as of April 19, 2011:

iShares Dow Jones U.S. Oil & Gas Exploration ETF
1) Occidental Petroleum Corporation
2) Apache Corporation
3) Anadarko Petroleum Corporation
4) Devon Energy Corporation
5) EOG Resources

SPDR S&P Oil & Gas Exploration & Production ETF
1) Petrohawk Energy Corporation
2) Gulfport Energy Corporation
3) Cabot Oil & Gas Corporation A
4) Stone Energy Corporation
5) W&T Offshore, Inc.

3)      Exchange Traded Notes – this structure is different than a traditional ETF in the sense that an Exchange-traded note (ETN) is really a structured note, generally issued by a corporate entity such as a bank – usually Barclays as it stands now.   As a result, the notes have issuer risk (i.e. credit risk) associated with them as it relates to the issuing entity. They also generally tend to have higher relative expense ratios when compared to the traditional ETF format.  Once such oil ETN available in the marketplace is iPath S&P GSCI Crude Oil Total Return Index ETN (Ticker: OIL).

We are not advocating one of these ETFs over another, nor do we currently hold any of these particular ETFs in our managed portfolios, but do encourage all potential investors to understand the mechanics of each of the various ETF structures before making, or even considering, an investment.   Based on our analysis, there is no perfect tracking mechanism available in the ETF marketplace for the crude oil market.  Please see the 2011 year-to-date (YTD) performance data from Bloomberg below to show how disparate the returns associated with these ETFs can be when compared to the crude oil spot market itself.  Please remember that past performance is not an indication of future results and this listing should not be misconstrued as being a complete listing of oil related ETFs.

Source:  Bloomberg, April 19, 2011.  Past performance is not an indication of future results.

*Information from sources we believe to be accurate, but we cannot guarantee the information.