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All about oil

A commodities ETF tends to favour oil – whether or not that’s favourable.

To be a commodities ETF is not a pretty thing. In the past year a fund like the iShares Commodities Select Strategy has shed about a quarter its value from over $50/share to under $40/share. The abysmal performance has come on the back of oil. Exposure in the fund is heavily weighted to energy futures and equities. They make up close to three quarters of its holdings (mostly futures). The price of crude oil collapses by half, more or less, and so a commodities ETF like this follows.

Few commodities did so poorly as oil in the past year so, here, a generalist commodities fund shows its Achilles heel. The pain may be somewhat dampened as a basket of futures in other commodities insulates the generalist commodities fund from oil’s freefall.

It’s hard not to tie its future to the very same with such heavy weighting to energy, dominated by oil and gas, which lubricate the global economy. The strings of a commodities ETF like this – energy dominant – are pulled by the dynamic of supply/demand in energy. It revolves around questions in the near term such as: Iran, the major supplier, how will sanctions affect supply? And longer term, how will China grow and how will resurgent energy production in the US affect supply?

Oversupply remains the confounding question for oil prices and so a commodities ETF weighted to it. US oil and gas production has skyrocketed in recent years owing, largely, to drilling of unconventional oil formations. Oil production has nearly quintupled in five years in key emerging producing regions including the Eagle Ford, Bakken and Permian basins. The overhang on supply here, however, is how quickly drilling falls off as oil prices plummet. So-called “tight oil” in these new oil and gas producing regions is more expensive to liberate because it’s just that – tight. It requires extensive drilling and fracking to get it out of the ground. So when prices of oil plunge so goes, to a large degree, the incentive to extract.

It seems a good time in this regard to follow production and drilling trends nicely compiled by the US Energy Information Admnistration (EIA). Analysts increasingly follow it, watching how booming production could – somewhat open question here – respond to declining drilling.

Meantime, there is the ever present question of oil production from more conventional yet unstable sources affecting the balance. Iran is now key focus. Could Iran-US nuclear negotiations free more oil supply from the oil rich country? A couple years ago sanctions on Iran heavily curbed production. But production could surge again if the US allows it. That could mean more oil supply to a market that seems, for now, well supplied. That could push oil prices lower. Barclays recently notes, “Our view is that if the market is looking for a trigger for its next fundamental move downward, the perception of sanctions relief could pave the way.” If that be the case, there will be more pain for energy commodities.

Yet, the case otherwise will be worth watching, especially beyond the next few months. Energy demand is strong, overall. China is driving it. So if it becomes apparent that supply weakens in the US, and beyond, prices could respond. So too will commodities funds, slanted as they are to energy.

** This is a sponsored education series focused on offshore investing. The content is sponsored by Standard Bank Webtrader and Moneyweb are the content creator.


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