Energy is a common enough commodity, but investing in energy and related exchange traded funds (ETFs) requires a little finesse. Despite being one of the most profitable sectors in the last decade, the energy sector has had a challenging couple of years.
What Is the Energy Sector?
The word energy encompasses a broad range of things relating to the sector. The sector includes oil and gas exploration companies, energy retailers, electric utilities, alternative energy. Then there’s nuclear, coal, natural gas and more.
Energy and fossil fuel powers daily life, particularly in developed economies. Gas runs our cars, natural gas helps us heat our homes and cook our food, even the sun and wind provide energy that utilities are increasingly looking to harness.
But energy is a sector that faces challenges.
A number of factors have hit the sector in recent years: an oil price bubble that burst, the BP oil spill, a ban on offshore drilling and the possibility of new taxes and restrictions on investing in the sector have all had an impact on both prices and public perception.
Energy Prices
Energy is also one of the more volatile subsets of commodity investing. In general, commodities can move quickly and what was hot this month may not be next month. This has become especially true in recent years. Among the events and occurrences that can send shock waves through the energy markets and send prices soaring include:
- Political events. This often refers to pipeline bombings, which aren’t unusual in the Middle East and Africa, in particular.
- Weather. A strong hurricane is enough to send natural gas prices soaring because there are a number of natural gas rigs in the Gulf of Mexico. A period of intense heat or cold can also push demand for energy higher.
- Supply and demand. If consumers aren’t using enough oil and a glut forms, prices will fall. If consumers increase demand and it leads to a shortage, prices rise.
- The dollar. Oil and many other commodities are priced in U.S. dollars. When the dollar becomes weaker, oil becomes cheaper for investors overseas, which helps drive demand.
The bottom line is that when it comes to oil prices, it’s important to anticipate some volatility and take extra steps to protect your clients’ portfolios with some kind of exit plan, if using one becomes necessary.
Diversifying with Energy ETFs
Why would you invest in energy?
Well, historically, most energy commodities have maintained their value against rising inflation. Additionally, energy prices are inversely correlated to the U.S. dollar, which makes energy ETFs a good hedge against a depreciating dollar.
The demand is not only there, but it’s increasing, too. As emerging markets continue to industrialize, demand for energy commodities is expected to continue to grow. It is unlikely that oil reserves will continue to satiate our appetites indefinitely, so we may be faced with a future of rising demand with slowly decreasing supplies.
But that, of course, will only present further opportunities for investing in other types of energy: solar, wind, natural gas, nuclear power and so on.
Modern portfolio theory suggests that investors may increase portfolio risk-adjusted returns by using low-correlating assets. Oil is one such investment that produces a low, or even negative, correlation with U.S. stocks. But always be sure that you’re ready to keep an eye on these investments and have an exit plan in place.
There are two primary ways to get exposure to energy via ETFs:
- Equities. This includes such funds as PowerShares Dynamic Oil & Gas Services (NYSEArca: PXJ), iShares Dow Jones U.S. Oil & Gas Exploration (NYSEArca: IEO) and Guggenheim Solar (NYSEArca: TAN). These and other similar ETFs simply track an index of companies involved in the manufacturing and production of energy.
- Futures. The other type of energy commodity ETF tracks a basket of futures contracts. This is a relatively new area for many investors, who would have found it cost-prohibitive and time-consuming to invest in futures. This type of ETF includes funds like United States Natural Gas (NYSEArca: UNG) and PowerShares DB Oil (NYSEArca: DBO). When investing in these funds, be sure that you understand the impact that contango might have.
To get started on investing in energy ETFs for your clients, there are a few ways to get started:
- You can check out one of our many model portfolios; several of them include energy exposure.
- You can find commodity ETFs in the ETF Analyzer, and then add them to your Watchlist on the ETF Dashboard.
- Once you have some energy-related ETFs in possession, set up alerts to be notified of a trading opportunity.