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Three reasons I bought a mini portfolio of oil shares instead of an energy ETF

Posted By The Investor On In Shares,Investing | Comments Disabled

It’s been ages since I reported on my active investing adventures [1], so let’s look at my most recent dabble in oil shares.

Sensible passive investors among you might prefer to brush up [2] 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. [3]

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 random selection of UK-listed second tier oil companies. [4]

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 [5] 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 [6].

Surprised? Maybe even a bit scared, in light of the graphs above?1 [7]

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:

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 [9] Oil & Gas Exploration ETF?

There are certainly many advantages to going down the ETF route:

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 [10] 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, [11] once I’ve used my annual personal allowance.

Now, I’ve been trying my best to defuse [12] 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 [13]. Legally avoiding taxes [14] 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 [15] 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 [16] 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!

  1. Of course I am only talking about the UK market here – a global tracker [21] would have more like 6-7% in energy. [↩ [22]]