It’s been ages since I reported on my active investing adventures, so let’s look at my most recent dabble in oil shares.
Sensible passive investors among you might prefer to brush up on the reasons why index funds will likely prove a better bet than messing about like this.
Otherwise you’re welcome to grab some popcorn and read on through your fingers – Doctor Who-viewing style – while hiding as you see fit behind the sofa when it all gets too much.
Peak oil foiled (again)
Over the past year or so the oil price has collapsed, from over $120 to below $40.
It’s happened because Saudi Arabia has flooded the world with cheap crude in an attempt to force more expensive US producers to cut production, enabling it to regain dominance as the swing producer that can dictate the market.
I’m not going to go into my views on this or we’ll be here all day.
Suffice to say the oil price plunge has smashed the economics of finding and extracting oil across the globe – especially for oil explorers that bulked up with abundant cheap debt in the good times and bet it all on black.
The following chart reflects how integrated oil giants BP and Royal Dutch Shell have suffered since August 2014:
BP and Shell have slid down the slippery slope.
Incidentally, the major reason for the FTSE All-Share’s relatively lousy performance over the past few years has been the collapse in the value of mining giants like BHP Billiton and Rio Tinto, and latterly the oil behemoths.
Ignoring dividends, the FTSE 250 is up about 55% over the past five years, compared to just a 10% advance for the commodity-crowded FTSE 100.
That’s not to say mid-sized and smaller oil companies have escaped the rout:
A fairly random selection of second tier UK oil companies.
As you can see from this blurry selection of slippery slopes, smaller oil firms have done even worse than the integrated big boys. BP and Shell can at least offset the weaker returns from their upstream – i.e. exploration and production – activities by boosting their returns downstream, where cheaper oil is a benefit.
(Hey, they didn’t become giants for nothing!)
Oh, in case you’re wondering, that red line in the graph is a flat-line – Afren PLC, which is now deceased, an ex-oil explorer.
Afren was worth nearly £2 billion at the start of 2014…
It’s a sobering reminder that individual shares can go to zero, and that investing in stocks is a risky way to go about this business.
Oil have some of that, thanks
Still, that was then and this is now. I’m interested in where share prices are going, not where they’ve been.
And while it’s certainly hard to muster up much enthusiasm for the mining and energy sector at the moment, the sheer revulsion and despair in the market has had my Spidey senses twitching all year.
Sadly, those Spidey senses must have been on the blink, because they have cost me as prices have kept falling.
Indeed after holding barely 2% of my portfolio in commodity companies for most of the past five years – compared to a weighting of well over a fifth of the FTSE 100 at the peak, from memory – I’ve spent this year attempting to roar into the market with shock and awe to frighten the world’s hedge funds into a buying frenzy and so trigger the bottom of market.
Oops, did I say that out loud?
Okay, not really.
More metaphorically realistically, I’ve sneaked in via the backdoor into the maelstrom of the market’s mega-casino, put my meager wagers down on the bargain tables at the back with the other grannies and kids blowing their pocket money (if you’ve seen the movie Swingers you’ll know the tables I’m thinking of) and then snuck back out again when my moves have gone against me.
The good news is I haven’t tried to ‘fight the tape’ as the lingo has it, referring to Ye Olden Days when stock prices would emerge like Fortune Cookie carrying leaf-cutter ants marching out to the assembled gangs of hoary old investors losing their life savings in the bucket shops of Mid America.
No, I’ve just cut and run.
However I’ve recently decided enough is enough – that it’s time to hold my nose, buy some exposure, and aim to keep it.
The thing is, I can see value in the commodity sector from a long-term perspective.
Yet I am actually massively underweight compared to those of you who are sensibly invested via UK tracker funds and getting on with your lives, given that the weighting of materials and energy is about 18% in a FTSE 100 ETF.
Surprised? Maybe even a bit scared, in light of the graphs above?1
The truth is it’s hard to actively own something that stinks, however much of a contrarian value hound you aim to be.
Not being confronted with the reality of what you are invested in can be another big advantage of trackers:
Painfully forcing myself to add commodities & EM to my active portfolio = another reason why trackers win, they hide the sausage making!
— Monevator (@Monevator) November 18, 2015
Active investors are notorious for selling after stock market crashes and not getting in until well after the recovery has begun, and the same thing can be true on a sector basis, too.
Having dodged pretty much all of the mining and energy company crash of recent years (outside of my tracker holdings, of course) it would be somewhat Pyrrhic to miss the recovery.
Sector ETF versus a basket of stocks
If you’re thinking this was a lot of preamble just to set the scene for why I bought a bunch of oil stocks, you’re right.
Count yourself fortunate I haven’t shared my activity with you all year! (My passive investing co-blogger The Accumulator would be turning in the early grave that the fees alone would send him to…)
Anyway, the big question is why didn’t I just buy a relevant ETF, such as the iShares Oil & Gas Exploration ETF?
There are certainly many advantages to going down the ETF route:
- It’s cheaper to buy a sector ETF than a portfolio of different stocks (just one trade, tight spreads, and no stamp duty).
- An ETF is much more diversified than my little basket of oil companies.
- I’m really looking to make a bet on a sector, not a bunch of stock-specific factors.
- We’ve seen individual oil companies can go to zero!
- Even giants like BP with its Gulf spill have proven the riskiness of owning individual commodity companies.
All true. In this respect sector ETFs have been a boon for active private investors.
Jack Bogle and other indexing purists might not like them because they tempt passive investors into playing active, but equally they can reduce the risks of active investing by introducing some of the benefits of passive funds.
I had a few reasons why I wanted to buy a basket of oil shares in this instance, though, which I’ll run through in a moment.
Before I do that I’ll just add that I do own the iShares ETF I mentioned above in my ISA, as well as some closed-ended commodity investment trusts, in addition to this basket of smaller oil companies.
However I had reasons for wanting to own shares directly, too.
Reason 1: I can set any losses against capital gains
To be clear, these reasons are ranked in order of importance – and the biggest of my reasons for buying this mini-portfolio of minor oil stocks is to potentially help with tax loss harvesting.
I need to do a whole article on this advantage of unbundling your holdings, but here’s the gist…
Long-standing sufferers readers may recall that my tardy start with ISAs – combined with a massive savings ratio and decent returns – means I have a big portfolio outside of ISAs and SIPPs, in addition to all that I’ve managed to get into such tax-advantaged sanctuaries.
I’m no longer holding anything outside of tax shelters at a loss, which means that if I want to sell any of these holdings I’m potentially liable for full whack Capital Gains Tax, once I’ve used my annual personal allowance.
Now, I’ve been trying my best to defuse these gains over the years.
But with the (admittedly high class problem of) rising share prices that we’ve seen, the non-ISA portfolio – and its gains – has grown much faster than my ability to tax efficiently ‘harvest’.
Worse, the M&A boom of the last year or two has forced me to realize gains where a company I own has been taken over, even if I’d rather not have done so.
Tax on your investments is a big deal, which can greatly reduce your returns. Legally avoiding taxes on gains is a more certain route to boosting your wealth than taking on yet more risk by buying more shares or riskier ones.
So, my thinking is that by buying a portfolio of individual oil companies, I will have a spread of different bets, instead of the single bet I’d make with an oil ETF.
If the sector continues to deteriorate, then it’s unlikely the pain will be felt uniformly across my basket of companies.
Rather, some will do worse than others, generating larger capital losses.
In addition the greater granularity of the losses across individual holdings will give me more flexibility as to how I realise said losses.
Losses I can then set against the gains I’m carrying elsewhere.
What’s more, I can easily maintain my general sector exposure despite realising losses in some particular oil company by using the money released to buy into another oil company – without violating the 30-day CGT rule.
Very important note: I am NOT buying into this sector because I expect losses, just to reduce my tax bill. That would be mathematical madness!
I expect to see gains from the sector over time, but I concede more losses are likely – especially in the short-term.
By investing in a basket of stocks outside of ISAs, some of the downside is protected, as I can exploit that choppiness by offsetting any losses I suffer against gains elsewhere in my unsheltered portfolio.
Reason 2: I want exposure to small-to-mid-sized UK companies
The iShares ETF I mentioned earlier is dominated by US and Canadian exploration giants.
I want exposure to small-to-mid sized UK oil firms.
I am not aware of any ETFs that give me pure exposure to this space, nor any investment trusts for that matter. (There is a mutual fund called, confusingly, the Junior Oils Trust, but it doesn’t hold what I want and it’s expensive).
UK small-to-mid cap is where I feel I may have an edge in judging the pain in the sector and also investor sentiment. I have been reading about these companies for a decade.
Hence I’ve bought directly into shares to get the specific exposure I want.
Reason 3: I can use my stockpicking ‘skillz’
This is the most spurious reason. I am not an expert on the energy sector by any means. I am not even really a knowledgeable amateur.
However I do know enough to try to assess which companies are less at risk from a prolonged slowdown in prices, both from reading their own reports and also from the research of others.
What I’ve started to assemble then is a portfolio of smaller companies that I believe are likely ride out the storm, reducing the risk of this move into buying and holding energy firms.
To be sure, even assuming I can accurately assess such risk (you’re justified a “really?”, followed by a hard stare), this wouldn’t be the only way to reduce it.
Lars Kroijer explained last week how you can use bonds to balance the return premium you expect to get from equities, in order to dial up or down your overall risk exposure.
The same is true of any investment.
To reduce risk I could have instead put less money into a more motley collection of companies, and held the balance in cash or even in the broader market.
However given my ambivalent attitude towards seeing losses here (reminder: reason one) I felt this was the way to go.
Bonus reason: Psychological
I mentioned my luck nifty trading has meant I haven’t hung on to collapsing oil shares as the rumble has turned into a rout.
That’s obviously been a big benefit to my portfolio’s bottom line.
At some point though I know my luck will run out, and I’ll need to put down a marker in the space – and hang on to these investments once the tide turns in their favour.
I don’t know when things will brighten up for energy. I think perhaps once the Federal Reserve starts raising rates and everything is priced in, most probably within the next year, very likely in the next three, but it could take far longer.
(Or never. That’s also possible.)
In any event, if I don’t have exposure whenever the sector comes back, my portfolio will have to work much harder to justify its existence versus just holding a FTSE tracker that will likely be levitating as its commodity holdings rise.
By buying a bunch of commodity companies outside of an ISA, where for various reasons (mainly tax and paperwork) I’m less likely to trade them, I’m putting them into a different mental ‘bucket’ within my portfolio.
It’s the same psychological bucket that I plonked various small caps into back in 2009-2011.
Some of those have tripled or better, yet I know I’d probably have sold them long before that if I’d held them inside tax shelters, if I’m honest with myself.
A drop in the ocean
Set against these reasons are of course the far higher costs of establishing this basket, and the far greater risks of owning it versus an ETF, let alone an ETF of larger, safer companies.
However by definition risk is what I’m embracing with this investment. I want exposure to the risk of an oil price recovery!
Also, I was able to take advantage of a cheap dealing window with my broker, which cut the dealing fees by more than two-thirds.
Several of the shares were stamp duty exempt, too, which also helped.
For context, this entire basket is only worth a little over 2% of my portfolio, though I do expect to add to it (or for it to grow). I have also bought that aforementioned oil explorer ETF as well as some commodity investment trusts within my ISAs.
Finally, I’m not suggesting this is a great idea that anyone should copy.
It may well be a dumb idea that will cost me dearly.
But I thought the tax aspects of unwrapped holdings at least might be of interest to some of you.
Good hunting!
- Of course I am only talking about the UK market here – a global tracker would have more like 6-7% in energy. [↩]
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I’m not an energy expert but as I know oil is source of energy like coal:)
http://mebfaber.com/2015/11/11/why-you-should-ask-for-coal-stocks-in-your-stockings-this-holidiy-season/
Nice article. Not dumb at all really: you are using 2% of your portfolio to make a long-term value buys in a basket of individual stocks with your eyes wide open to most of the risks, the most important one being potential for 100% loss.
As long as the other 98% of your portfolio doesn’t follow the same strategy I think that is called diversification 😉
I, and my children through JISAs, are now getting back into energy, and also gold, on a medium-long term outlook. I should say into funds, not individual stocks, and with more like 10%-15% (we’re all young). The next few years look set to be good and if they aren’t it’ll come good soon enough for us.
Well….I’m a petroleum engineer who’s spent the last 15 years working for majors and minors worldwide and been ‘investing’ in them for the last 9….. and the recent rout has given me a real spanking. Nevertheless, recent valuations have me back at the table.
I think you are right to select individual stocks in the small/mid cap arena. There are some truly terrible management teams out there who stagger from fund raising to fund raising keeping their zombie companies afloat purely to pay their own salaries. The oil price drop of late has been a smoke screen for dollops of management ineptitude. You only have to look at how many small caps are trading at discounts to their cash in the bank to see how highly the market views the skills of the board/management to invest it.
There are still a few gems in my opinion and I continue to try and find them. I think its important to understand the story, hold until it plays out, sell without emotion if it starts to unravel and accept that you might lose the lot.
Best of Luck
> The truth is it’s hard to actively own something that stinks
It’s a dirty job but somebody has to do it. So far taking a little bit of heat on oil and commodities too, but I don’t think we’ll be giving up oil that soon either…
Double down!
so what about the “carbon bubble”? either we leave the majority of fossil fuels in the ground, or temperature rises will exceed 2 degrees. fuel which can’t be burnt – “unburnable carbon” – is worthless. oil shares do not appear to be priced on the assumption that a significant part of their assets will become worthless. they will have a long way to fall if that changes.
also, if not all the known reserves will be burnt, then there is no need to find even more oil, and oil companies are wasting a lot of capital by continuing to spend on exploration. so the companies would need to be run with different objectives if there is such a thing as “unburnable carbon”. though they would continue to exist, except perhaps for explorers without proven reserves.
are you effectively placing a bet that we will go ahead and burn the lot, even if there is a 5 or 6 degree temperature rise? perhaps if it is a small enough bet, it is more like a hedge. in that a large temperature rise could damage many parts of the economy, but perhaps at least your oil stocks would be doing well.
I’m not entirely sold on the tax loss harvesting – it seems to me all you are doing is pushing the tax down the road (presumably not hoping to die in the meantime!) at the cost of being less diversified and taking more stock specific risk (because you end up stuck with your winners).
Say you invest £100 equally into 10 stocks (£10 each), 5 of which go up 50% (so are worth £15) and 5 of which go down by 20% (£8). So overall you are up 15%, and let’s suppose this is in line with the return of the one ETF you’d otherwise have bought.
You can sell the 5 losers, lock in your 20% losses (£10) and offset those against gains of £10 elsewhere. So far so good – if you’d sold any quantity of your ETF, you’d be locking in a gain and increasing your tax bill – but here you’ve saved some tax.
But that still leaves the 5 winners, and sitting on £25 of gains no less. You’re now effectively stuck with these, until you can stomach the tax bill to sell. If you were less diversified than the ETF with 10 holdings, you are even less so with 5 (so let’s hope the 5 you end up with really are long-term keepers!). The £15 net gain to exit all 10 stocks is still the same as the ETF.
As an aside, you also can’t temporarily rotate from the losers into the winners when tax loss harvesting to maintain the same overall exposure, as you won’t be able to rotate back from winners into losers after 30 days without crystallising gains on the winners.
And, of course, if what you buy temporarily while tax loss harvesting goes up over 30 days, then you either have to stick with that too or undo the benefit of some or all of the tax loss harvesting.
@gregory — I have a very small investment in a coal-related company, but in general I’m pessimistic about the asset class. If we’ve got any sense as a species we’ll stop burning coal ASAP. Oil is cleaner / lower CO2. Gas much more so again.
@B Boy — Well, with my other commodity investments (e.g. ETF and closed-end funds) I am more like 7%, and I also have further exposure via beaten-up services companies. (There’s not much point me discussing my allocations though as they’re very fluid, especially within the tax shelters!) I too am thinking about gold, across all its various formats, but haven’t pulled the trigger on this yet. Have a half-written post that I’ll try to finish for next week on it!
@Bob – Cheers for your thoughts. I am pretty confident in all the management teams here (with perhaps one exception) and none of my holdings are from the “fingers crossed they kick out the management before the cash runs out” end of the spectrum. 🙂 Time will tell. If oil stays at $40 for 2-3 years even these holdings could be in real trouble, not least because some hedges will roll off next year, but that should be offset by a low-cost energy boom elsewhere in my portfolio! But I don’t expect that.
@ermine — Hmm, yes, I think I talked to you about commodities earlier in this downdraft…Been deeper than I for one expected! Beware (with your income needs) that dividends could get the chop soon, especially in mining, with the likes of BHP. (Personally I’d welcome it — much better uses for that cashflow right now!)
@The Rhino — Always!
@grey gym sock — Well the first thing to say is a UK-focused passive investor has more exposure to the carbon bubble than I do; I’m still actually underweight, even including my service company exposure! 🙂 But I do hope to move to an overweight if/as momentum returns. The carbon bubble is a live issue, but I would place approximately near-zero odds on it being a major factor in the next 5-10 years. If you consider many people still don’t actually believe the overwhelmingly convincing case that man has changed the climate, let alone accepting cuts and so forth, you can see this isn’t going to be hurried. Look how the Left effectively managed to goad the Tories into cutting green investment via all their harping on about high energy bills! People moan about this stuff but aren’t prepared to pay up for the alternative at the moment, let alone accept a cut in their standard of living.
Beyond that, there are big differences across the spectrum. So coal will definitely go first. At the other end you have a company like Shell which in my opinion would be a big winner in a de-carbonisation effort, just because such a project would be a 10-30 year move at fastest I’d bet, and Shell has lots of gas and so forth. Cairn Energy is another one, from memory. (I read an investment bank’s research note on all the majors and what would be the hit a few weeks ago, but haven’t got it to hand).
I am very bullish about alternative energy technology, and have argued with Grumpy Old Men / engineer types for years about its prospects. (I think Ermine, who fits only one of those categories, can vouch for our spirited disagreements in this area over on his blog over the years). And we’re already seeing for instance solar come through as a viable competitor even without subsidies, years before anyone expected that.
The snag is we’re still adding a billion of mouths over the next few decades and many people today still live with a dire shortage of energy per capita compared to us in the West. I can’t see any practical way of getting across this bridge without burning a fare amount more fossil fuels. Hopefully carbon capture and the like will help. (I keep reading about stuff like concrete that absorbs CO2 as it cures over time. But there’s no incentive for the extra cost, yet.)
It has all the hallmarks to me of something my middle class chums will ring their hands over for my entire lifetime, while flying around the world on sunny holidays and driving 4x4s. I think it’s a live issue and I don’t discount it, but I’m not about to let it influence my investment in what I think is effectively a temporary market dislocation. (Oil demand is still increasing, and will only continue to increase with low prices).
Incidentally I have a theory that the Saudis are extra keen to retain their role as swing producer because they are scared they will not be able to burn all their reserves due to hardening attitudes towards global warming (again, on a 20-50 year view). Yet at the same time, I’ve also read that applying fracking to the Saudi fields could increase their already massive reserves by a factor of ten. (TEN! Again, how did anyone take peak oil seriously?!)
These are huge issues, and beyond the scope of my little portfolio/wager.
I’m one of the doubtless many unfortunate investors that thought they could get in oil companies on the cheap so to speak. Afren and LGO in retrospect were not great ‘first forays’ into the sector. I could fill a page with the goings-on at the former! I’ll be sticking to funds/ETFs from here on in. However, if OPEC ever decide to cut production again i’m considering a leveraged oil price ETF.
@Gregory – Mr Faber says:
“Ironically, the only industry to ever print 6 down years in a row? Coal stocks.”
What is ironic about that? Too much listening to 90s pop Meb? I can’t see anything in the post that justifies getting *coal stocks* specifically over an energy sector index fund. I really find Mr Faber to be one of the more obtuse finance bloggers. Not long ago he was talking about a way to play low bond yields by shorting low-yielding bonds. Short-selling is a ludicrous activity that results in huge fees and disastrous returns generally.
Makes perfect sense to me and has done since the first barrel tumbled a few months back.
Forgive my simple thought process but there are millions of cars in the world. There is a lot of ground that needs traversing by people all over the world. Oil will be most likely necessary in the long run, despite advances in e cars etc. Also lots of other practical uses for crude oil e.g plastic, medicines.
This company link has an interesting presentation on crude oil
http://www.wintershall.com/en/company/oil-and-gas/oil-can-do-more.html
I know it’s not fashionable nor renewable but it is still a resource and we do love all its products much as we might aim for the ethical higher ground we are all standing on our forefathers bones..
@John — Apologies, I missed your comment as it came in while I was typing my masterpiece to @greygymsock last night. 😉
Now at work, so just briefly of course you’re right that there are downsides as well as upsides to this operation. And as I say in the post, it’d be particularly foolish if undertaken only for the tax reasons, or in isolation. Finally, nobody should go from a passive/fund-based approach to stock picking just for this reason.
But none is true for me. My new basket is part of a big portfolio that’s pregnant with big capital gains all over the place. I want to add oil energy exposure right now, regardless of how. And I’m very comfortable and experienced with juggling a portfolio of 40-60 holdings.
The point of the former is I may not choose to use the losses within this basket (I may offset gains on things that look much more ripe for realization) and the point of the latter two points is self-evident. 🙂
I’m convinced managing tax is a big and too often overlooked part of private investing. Indeed I was talking to someone in the financial industry in the US a few months ago who said he could foresee a world where index funds are replaced by robo-portfolios where you hold the index directly (in fractional holdings) and tax harvesting is specifically the reason for doing so. The US has different rules on taxes (both on holding periods and on taxes with respect to funds) that may make this differently advantaged to here, but an interesting viewpoint anyway.
Even deferring capital gains, which as you say is part of what is happening here (though not entirely, as we cannot know the future of either my gains/losses or of tax law) is not to be sniffed at:
http://monevator.com/deferring-capital-gains-to-reduce-your-final-tax-bill/
Another bonus reason, it’s fun to have a dabble picking your own shares and feel you are above the herd. Of course it’s hard to pick the bottom but to have a mindset that the depressed prices are on sale helps.
I’ve personally got a wad on RDSB as l like to collect chunky dividends while awaiting the recovery.
And, yes I’ve read all the articles and understand the rational logical reasons that passive is best but having tried it, it’s just so boring!
“The International Energy Agency expects demand to begin outpacing supply in the second half of next year. If that happens, prices must rise high enough to spur renewed investment in oil wells.” http://www.etf.com/sections/features-and-news/heres-real-story-why-oil-will-spike?nopaging=1
Out of curiosity can you reveal what stocks your mini portfolio comprises ?
TI: that makes sense: if there is no major change of direction in the next 5-10 years, your oil investments have time to play out. i can see why you think that’s likely.
on that basis, we are heading for a temperature rise of well over 2 degrees. which will have will lots of negative economic (not to mention non-economic) consequences. so perhaps i’m asking for a different article, about how we should invest on that expectation. though the answer might just be: invest the same usual, but expect lower returns.
now it’s clear that peak oil won’t start to really bite until well after climate chaos does, it’s not so important. otherwise, it would happen at some point, though it’s always been very difficult to estimate when. (and i wouldn’t rely on the accuracy of figures for saudi reserves. shell got into trouble for misstating their reserves, but the saudis do not have to worry about the disclosure rules which apply to quoted companies.)
@Alan P — Sorry to disappoint, but I very rarely talk specific stocks on this site for a variety of reasons, the biggest of which is it’s not really at all the focus of what we’re about here (and it’s also a massive distraction from the main points! 🙂 )
Interested to know how your basket of small cap oilies worked out or were your stops hit before the recent upturn in prices?
@bob — From memory, the majority of that basket was eventually sold at a loss for CGT defusing purposes and I switched to energy ownership in tax shelters via various bits and bobs. It was a very churn-y time, as I’m always nervous holding commodity companies when they’re going down!