Unrest in the Middle East usually means supply-side problems for oil, and the current month-long conflict raging in Libya is no exception. Although Libya is only the 17th-largest oil-producing country in the world, the country remains an important supply hub, as it holds Africa’s largest crude reserves. As a net exporter of oil, Libya sold around 1.3 million barrels per day (bpd) globally last year, and as recently as January, it produced 1.59 million bpd for domestic use and export. What’s more, Libya exported approximately 100,000 barrels per day of refined oil products to OECD countries—mostly in Europe. Indeed, Austria, Ireland and Italy all receive over 20 percent of their imported oil from Libya.
As fighting continues in Libya, however, the International Energy Agency predicts the country’s exports will remain nonexistent for many months. Foreign companies have long since pulled their staff from the country, and the chairman of Libya’s National Oil Co. said production has fallen to less than 400,000 barrels a day as a result. Lawrence Eagles, head of commodities research at J.P. Morgan, said, “Our operating assumption is that there will be very little Libyan oil exported in 2011.”
While Saudi Arabia has somewhat filled the production gap, don’t expect OPEC as a whole to step in and increase its quotas, for it has stated several times that plenty of supply already exists in the market. Qatar’s deputy prime minister and former oil minister noted, “The disappearance of the Libyan production hasn’t really affected supply and demand, because we see compensation from other sources. When I look to the inventory, I see that the inventory is very high, over 60 days.”
Ripple Effect Across Equities, Futures
As history has taught us, nothing in the oil market is an isolated event—especially when it’s happening in the Middle East. And given the tight correlation between WTI and Brent crudes lately—over the past 40 trading days, the two have shown a daily correlation of 0.93—many investors are looking to oil markets closer to home to play events overseas.
To invest in WTI crude, ETF investors have two main options: futures, and equities funds. Let’s look at each in turn.
As proxies to the oil futures market, I’ve chosen the United States Oil ETF (NYSE:USO) and United States 12 Month Oil ETF (NYSE:USL); both ETFs hold futures contracts, though with different strategies. USO holds front-month oil contracts, rolling to the next contract each month as the current one expires. Obviously, this strategy has its pros and cons; USO is left exposed to some of the harshest effects of contango, but it can also benefit from front-month backwardation.
USL, on the other hand, spreads its holdings out over the next 12 months’ worth of contracts. This strategy mitigates the negative effects of a front-month roll during times of contango, but it also dampens any benefit from backwardation as well. (See HAI: The Contago Report for the latest contango curves.)
For equities ETFs, I’ve chosen three SPDR funds ETFs: the Energy Select Sector SPDR Fund (NYSE:XLE), the SPDR S&P Oil & Gas Equipment & Services ETF (NYSE:XES) and the SPDR S&P Oil & Gas Exploration & Production ETF (NYSE:XOP). All three ETFs track U.S.-traded oil and gas companies, although each concentrates its holdings differently:
- XES holds 48 fairly evenly weighted companies in the equipment and services sector, such as Complete Production Services (NYSE:CPX) and Carbo Ceramics Inc. (NYSE:CRR).
- XOP has the largest number of companies in its holdings, at 73; its holdings primarily engage in exploration and production. Gulfport Energy Corp (Nasdaq:GPOR) and Southwestern Energy Co. (NYSE:SWN) are its top two holdings.
- XLE offers broad exposure to the sector as a whole, though its top holdings are concentrated in big hitters Exxon Mobil Corp. (NYSE:XOM) and Chevron (NYSE:CVX), which make up 30.36 percent of the holdings.
(All holdings data is as of Friday, March 18.)
Looking back over the past year, equities have outperformed oil futures by quite a bit. The exploration and production companies in XOP propelled this fund to the top of the pack; the ETF gained 42.4 percent, well above increases seen in spot crude.
On the other hand, persistent contango in WTI crude obviously took quite a bit out of returns for USO (and, to a lesser extent, USL). Spot WTI was up 23 percent over the past 12 months, while USO is up only 2.6 percent. USL, meanwhile, seems to have performed as designed: Mitigating much of contango’s effect, the fund shows a healthy 15 percent return for the past 12 months.
The same story holds true when you look at performance year-to-date.
The range of returns isn’t as wide over the past three months, but equities still post higher rates of return than futures. In fact, all three equity ETFs exceed WTI’s spot rise of 10.6 percent.
But as you narrow the window, a different picture begins to emerge.
As the Middle East has heated up over the past month, so too have funds holding futures contracts. Spot crude is up almost 20 percent, and USO is up close to that, posting a 15.8 percent return. USL doesn’t perform quite as well, rising only 9.3 percent, but that’s no small increase.
Oil equity funds, on the other hand, aren’t even close. XOP remains the top performer of the three, with a one-month return of 3 percent, but XES actually declined, dropping 0.23 percent.
As supply uncertainty hit the market, the price of oil increased, thus sending USO and USL up. At the same time, equity investors grew nervous about what higher oil prices could mean for the global economy, thus putting downward pressure on equity prices—hence the difference in performance.
So what does all of this tell you? Unsurprisingly, USO shows the effect of short-term news sharply—political turmoil in the Middle East shows up faster here than in any other fund—but the market as a whole is not immune. Higher oil prices put downward pressure on the economy, and equities reflect that.
Still, if you’re looking for a long-term bet in the oil sector, equities ETFs have outperformed futures ETFs substantially, even during times of higher oil prices.
Keep An Eye On Yemen
While the unrest in Yemen isn’t dominating the headlines like Libya’s, it is something to keep an eye on. Yemen may not be a major player in the oil market, but it is close to Saudi Arabia, and its neighbor has already helped quell report by Bahrain’s Shiite population (something that Saudi Shiites aren’t too pleased about) Should Yemen completely melt down, an influx of refugees could crowd across the Yemeni-Saudi Arabian border—which is by no means secure—thus destabilizing the region and potentially impacting oil production in other areas, as Saudi Shiites turn out to protest.
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