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Investing With Russian ETFs

Summary With the majority of ETF options holding energy companies, the market has become a tradable opportunity for those looking to profit from volatility. The mid-term outlook remains bleak, as economic and political deficiencies have suppressed business growth in the country. For longer-term investors, the current market may provide an opportunity to build holdings in an emerging market portfolio. With the recent decline in Russian markets due to the drop in the price of oil, many interested investors have considered gaining exposure to the country. From a fundamental perspective, the nation’s abundance of resources provides a positive picture in the long term. However, the pertinent question is how investors can gain this exposure while also protecting themselves from unwanted paperwork related to direct investment in the Moscow Stock Exchange (MICEX). In the current environment, the best solution are the Russian ETFs available on the market. ETFs have become a popular tool in the past few years for diversifying portfolios and protecting investors from market volatility. For those considering exposure to the emerging markets, ETFs have become almost a necessity in the current decade, as global rates continue to decline and result in increased market volatility. Russian ETFs protect an investor’s portfolio from the large fluctuations in the MICEX while also offering a passive investment style which ensures even investment in all major Russian industry players. Many Russian ETFs have underperformed in the last year, due to continued pressure from a commodity price perspective. This period of pricing pressure provides an opportunity for investors to take on risk and bet on a recovery in the market as the price of oil recovers. Russian ETFs are not for everyone and while they offer reduced volatility compared to the MICEX, the outflow of funds from Russian ETFs in the past few months has reduced liquidity. In addition, a majority of the Russian ETFs are heavily invested in oil majors, a market that has taken hits due to sanctions related to the Ukraine crisis. For this reason, finding an ETF that offers exposure to oil while also targeting other industries is much more beneficial from a medium-term perspective. In the following article, I will cover three popular Russian ETFs to determine whether the current investment products available offer any opportunities for interested investors. Current market As many investors may already know, Russia is among the top oil producers in the world, ranking eighth in global proved reserves with 80 billion barrels of oil (BBL). That said, the Russian economy has been highly leveraged to the price of oil for several decades, as 60% of the country’s export balance comes from oil and gas, which also contribute 30% of its GDP. It is frightening to see how unsustainable the business model has been for the country, as it has leveraged itself highly to the primary industry and to commodity prices. From a productivity perspective , the average Russian worker contributes $25.90 to Russia’s GDP, while a US worker adds around $67.40. The gap in productivity relates back to the systemic deficiencies in the country as the political environment has weakened the country’s incentive to engage in international trade. The nationalistic behavior seen across the many Russian political groups has not only been limiting to the current generation, but will also create future deficiencies, as the current economy has set a precedent that the future generation is set to follow. Vladimir Putin looks to continue his reign in the country as propaganda from the Kremlin continues to support his 86% approval rating. The future looks bleak for the economy, and I suggest investors look at the country as a tradable opportunity rather than an investment , due to the constant volatility in the MICEX. For investors who would consider exposure to Russia, using the price of oil as a lead indicator is the ideal way to trade the nation’s currency and any other leveraged investment products. Possible Investment Opportunities For interested investors, the top three ETFs available are the Market Vector Russia ETF Trust (NYSEARCA: RSX ), SPDR S&P Russia ETF (NYSEARCA: RBL ), and the iShares MSCI Russia Capped ETF New (NYSEARCA: ERUS ). This begs the question: Which option should investors choose, and at what time should these ETFs be implemented into their portfolio? In the following analysis, I will take a quick look at the holdings and relative stability of each equity to help investors determine how these investment product should be used. (click to enlarge) Table source: Author’s own work. Market Vectors Russia ETF Trust (click to enlarge) Source: Google Finance. Market Vectors Russia ETF Trust seeks to replicate as closely as possible the performance of the DAXglobal Russia Index (DXRPUS), a modified, market capitalization-weighted index consisting of publicly traded companies based in Russia. The product offers ideal exposure to the Russian market and should profit from an increase in the oil price as the economy sees a direct benefit from increased production. As previously stated, the oil and gas industries in Russia contribute 60% of the country’s export balance and make up 30% of the nation’s gross domestic product. With such an integral relationship between the commodity and economy, when comparing the ETF that follows the Russian economy, we can see that the decline in the price of oil has a significant effect on the performance of the equity. Therefore, for investors who would like to play oil volatility – or expect the price to recover to $100/barrel levels – the ETF should benefit greatly from the recovery and offer an easy way to profit from the recovery in the Russian economy, as output and trade increase relative to the price of oil. Looking at the respective ETF, the top three holdings are Magnit PJSC (8.14%), Surgutneftegas OJSC (7.89%), and LUKOIL PJSC (7.67%). Magnit is the leading food chain retailer in Russia with 10,728 stores as of June 30, 2015. The retailer’s infrastructure offers the company an expansive reach across the country. Twenty-nine specialized distribution centers allow the company to deliver to customers on a daily basis. Looking at the past year, the 30.3% increase in revenue signals how strong the company is in a recessionary environment. The company has shown incredible strength in the face of the recession, due to over 90% of products coming from domestic players — a strategy that protects the company from dangerous currency fluctuations seen in the past year. Currency translations have been a barrier that has limited the growth of many Russian-based multinationals. The fall of the Ruble, the nation’s currency, is primarily due to the drop in confidence related to the price of oil in addition to the fall in exports as sanctions continue to hit major trading partners. Surgutneftegas is an oil and gas producer with one of the largest refineries in Russia, Kirishinefteorgsintez. The company has not performed well in the last year, with net income declining by 3.93% as the price of oil continues to hit Russian producers hard. With costs declining, the company should be safe in the short to medium term, as the refinery business supports revenue. However, the price of oil needs to recover, as the company produces oil at around $60/barrel, an unprofitable level in the short term. Oil company LUKOIL is one of the largest oil and gas vertically integrated companies with the firm accounting for over 2% of global crude production and approximately 1% of proved global reserves. In the oil sector, the company is a behemoth, and should do incredibly well in the long term as it continues to monetize its large proved reserves throughout Russia. Looking at the domestic market, the company accounts for 16.4% of Russian crude production, while also contributing over 15.7% to total refined crude oil in the country. Unfortunately, with the decline in the price of oil and additional sanctions from several international economies, LUKOIL has been among the most affected, with revenues declining by 31% which translated to a 59% decrease in net income. In the current market, the company has attempted to hunker down and survive the downturn through reducing costs by 19% and increasing production by 5.2% to utilize well efficiency in the short term. While reserve efficiency and hedging strategies will protect the company temporarily, it is essential for the price of oil to recover in order to support enterprise profitability. Overall the company has not done well in the short term, and funds like RSX will need to wait a long time to recover capital losses. Looking at the Market Vector Russia ETF Trust, the equity offers an ideal way to play the Russian market with exposure to numerous large industry players. In my opinion, the company’s high exposure to Magnit will help the equity in the down-turn as the company is quite recession-proof from an earnings perspective. On the other hand, Surgutneftegas and LUKOIL offer exposure to the nation’s oil and gas industry which has underperformed. Anyone who is considering purchasing this ETF should be aware that the performance of oil is very important to show any strength, due to RSX’s 42.73% exposure to the energy industry. SPDR S&P Russia ETF (click to enlarge) Sourced: Google Finance. SPDR S&P Russia ETF seeks to provide investment results that correspond generally to the price and yield performance of the S&P Russia Capped BMI Index. The Index is a float-adjusted market cap index designed to define and measure the investable universe of publicly traded companies based in Russia. The Index component securities are a subset, based on region, of component securities included in the S&P Global BMI Equity Index. The ETF has declined by 34.39% YOY, primarily due to its high exposure to the energy market (49.39%), as the price of oil and gas have consistently underperformed in the past year. Looking at the ETF’s top three holdings, Public Joint-Stock Company Gazprom (15.44%), Oil company LUKOIL PJSC (13.41%), and Sberbank Russia OJSC (7.41%) make up the top exposure to the Russian economy. Looking at the ETF’s exposure from a sector-specific perspective, Energy (49.39%), Basic Materials (14.37%), and Financials (12.09%) make up majority of the fund. With such high exposure to the price of oil and the related positions of the fund’s portfolio, large amounts of capital has left the fund as its current market cap of $24.44 million USD signals the illiquid environment the product is facing. Compared to the Market Vector ETF, which has over $1.72 billion USD in the fund, the SPDR S&P Russia has been badly bruised in the current Russian downturn. While the fund will recover, the timeline is unknown at the moment, and I would use the current environment as a case to judge the strength of the fund. Significant money flows out of the SPDR ETF has shown that investors do not favor the equity as their first choice to gain exposure to the nation. Therefore, while I am sure that as oil prices recover in the following 3 years, liquidity will be injected into the fund and help fuel returns, the current downturn has illustrated how weak the fund is compared to other available options on the market. When investing in an ETF, the liquidity and size of the fund is extremely important to protect holdings. In addition, the fees that investors pay on a smaller fund versus a larger fund results in compensation for the portfolio manager to be higher, which attracts more experienced and successful investors. Looking at the price movement of the fund, the product has seen more volatility due to the fact that liquidity is much lower and any institutional buyers will move the price much more. Thus, I recommend that investors look for another option to gain exposure to the Russian market as this ETF has been severely weakened by the current downturn in the market and does not provide an option to avoid market volatility. iShares MSCI Russia Capped ETF (click to enlarge) Source: Google Finance. iShares MSCI Russia Capped ETF is a much newer product available for investors as it was released in early January of 2015. The equity was introduced in order for investors to play the Russian decline as the Ruble, the nation’s currency, continued to fall on the FX markets. As economic output declined and prices continued to drop in regards to the decline in oil, the ETF has taken a position in major industry players at fundamentally undervalued price points. For this reason when looking at the equity’s exposure from a sector perspective, the top three sectors are: Energy (53.75%), Basic Materials (14.28%), and Financials (14.01%). Looking at the overall objective and investment strategy, with a relatively stable fund size of $208.43 million USD, the equity has taken large positions in undervalued sector leaders in order to take advantage of the current downturn in Russia. Looking at the overall performance of the equity, the iShares MSCI Russia Capped ETF is the only one in its product class that has shown positive returns; YOY, the equity has increased by 8.88%. Looking at the ETF’s portfolio, the top three holdings are public joint-stock company Gazprom (17.50%), oil company LUKOIL PJSC (12.74%), and Magnit PJSC (7.42%). Magnit and LUKOIL were previously covered, so I will skip over these two companies and focus on the ETF’s top holding, Gazprom. The public joint-stock company is a globally recognized energy player with major business lines in exploration, production, transportation, storage processing, and sales of gas, oil, heat and electric power. The company holds the world’s largest natural gas reserves in addition to being the largest producer and exporter of liquefied natural gas in Russia. With such a strong position, the company’s domestic market share has reached 72% in the last year while global market share in the natural gas sector was around 12%. The size of the company illustrates the sheer strength and presence it has on the global natural gas sector, with reserves estimated at 36 trillion cubic meters, while oil and condensate reserves reached 3.3 billion tons. In addition to strong reserves, the company has the world’s largest gas transmission system capable of sending production over 170,000 kilometers. The strength of this network was seen in early 2015 when Ukraine were unable to pay Gazprom for its natural gas due to its limited cash reserves . The country and majority of Eastern Europe have become dependent on the company’s production which provides an ideal market position for Gazprom as operations continue to expand in the oil and natural gas sector. Looking at the YOY performance of the company, while sales have declined by 2%, the increased profitability of the company’s pipeline network in addition to positive currency translation as volumes in Europe increased resulted in a 29% jump in net income. In addition, the company has been focused on reducing its leverage in the past year as net debt has declined by 12% due to natural gas and oil operations continuing to expand. I believe that both Gazprom and LUKOIL will do well in the long run, as the fundamental stability of their proved reserves and established network across Eastern Europe should help the companies. For this reason ,when looking at the iShares MSCI Russia Capped ETF, I am confident that the current downturn will be beneficial for the new product, as positions have been opened at the bottom of the down cycle and should help the fund increase as the recovery begins. Looking at the overall ETF, while the 53.75% exposure to the energy sector remains quite worrisome in the current market, due to the product coming onto the market at the bottom of the investment cycle, I am confident that these new positions in major oil and gas leaders should increase profitability in the medium term. In Conclusion (click to enlarge) Source: Author’s own work. After analyzing these investment holdings and determining how each ETF could be used in an investment strategy, I would like to provide a final comparison in order to help first time investors choose the safest investment product. In the current market, the recent decline in the price of oil has rocked the Russian economy and increased recessionary pressures in a nation that produces over 30% of GDP from the oil industry. When approaching a nation like Russia, having a defensive strategy is extremely important in order to ensure that holdings can survive a volatile downturn like the one seen in the past year. The investment approach should not be shaped in avoiding a loss but rather surviving one. Compared to many other emerging markets, Russia has leveraged itself to the commodity trade greatly and this leads to a cyclical investment experience where long-term investors will add to positions in the downturn and profit off any increases in the price of oil or gas. Looking at the longer-term projection for oil, the following decade should see a recovery to the $100/barrel as demand should continue to increase in the long-term. The question investors should ask themselves is not if there will be a recovery, but when . Therefore, with that mentality, when selecting a Russian ETF, keeping in mind the longevity and downside protection of major positions in the fund is essential to choosing the right product. Taking a look at the overall performance in the past 6 months, all products performed relatively the same, with returns in the 4% to 6% decline range. Thus, investors should not base their assumptions on the short-term performance of each product. The products have been designed to diversify holdings while reducing risk against volatility through the timing of established positions, an investment goal that is achieved in the long term. (click to enlarge) Source: Author’s own work. After taking into account the short-term performance of all three products, and understanding the overall investment strategy adopted by these ETFs, I believe that the iShares MSCI Russia Capped ETF New offers the best opportunity for investors to gain exposure to the Russian market in the long-term. While the other products have been available to the market for a longer period of time, and have allowed investors to better judge their historical performance, the timing of the iShares product means that majority of the positions initiated in the fund have been at the bottom of the downturn. With the price of oil continuing to decline into the New Year, the start of 2015 marked one of the lowest points in the past four years in regards to the price of oil. This decline had triggered the collapse of the Ruble and eventual recession in the Russian economy as the equity and FX markets saw large outflows of money. That said, the iShares product came onto the market at this exact time, and looking at the type of holdings in the product’s portfolio, the ETF has over 53.75% exposure to the energy sector through beaten-down industry leaders. I expect that in the following decade, as the price recovers, while all three products have holdings in these major industry players, due to iShares’s timing on the market, I expect the recovery to be much more profitable for the product and its investors. Overall, while my suggestion may provide the safest and most profitable option among the three products listed, the current market is a time to build holdings in an emerging market portfolio. Whether a Russian ETF product is the way to go depends on the investor and his/her risk tolerance. In my opinion, with the political and economic uncertainty, implementing a Russian ETF into your investment strategy is a very tactical decision that ensures protection against further volatility in the market while also profiting from increased money flow.

How To Pick The Best Oil ETF

Summary Over the last 10 years, the number of oil ETFs has exploded with an increasing number of complex instruments available to investors to gain exposure to crude oil. Many such ETFs appear attractive to the profit-minded trader, but it is up to educated investors to determine which product is most appropriate given his/her objective, risk appetite, and timeframe. This article analyzes the most popular commodity and oil ETFs to determine which most effectively tracks the price of oil over a series of different timeframes. Commodities has arguably been the most challenging sector in which to turn a predictable profit over the past 10 years. Crude oil, the most popular commodity in the sector, has seen its price double, lose 75% of its value, double again and, most recently, drop by 50%. However, with great volatility comes great opportunity, and it is no surprise that oil prices earn front-page headlines on all major financial websites on a daily basis. For years, most small, individual traders were unable to trade crude oil. Direct trading of oil requires buying and selling of futures contracts, with one futures contract usually representing 1,000 barrels. With oil trading at an average price of $80/barrel over the past decade, a single contract would cost $80,000 — too risky for most recreational traders. Even with the necessary pocketbook, trading futures contracts is particularly dangerous in that they expire every 30 days, requiring a trader to cash out at undesirable prices or be forced to take physical delivery of the oil. That all changed in 2006 with the arrival of the United States Oil Fund (NYSEARCA: USO ), an ETF that bought and held oil futures contracts itself, and allowed traders to buy shares for under $100. Over the next 5 years, an explosion of new commodity ETF products hit the market that allowed investors myriad increasingly complex opportunities to gain direct exposure to oil. With so many products available, many investors do not understand exactly what sort of exposure they are purchasing and how closely it will actually track oil. This article does not attempt to convince you, the reader, to buy oil. Rather, it assumes that you have already made the decision to do so, and instead will discuss the most effective way to go long oil without buying futures contracts. With a market capitalization of $3.2 billion and average daily volume of 28 million shares, the United States Oil Fund is among the most the most popular commodity ETFs, and by far the most popular pure oil ETF. The ETF was launched in April of 2006 and was the first of its kind. It allocates about 75% of its holdings to oil futures contracts. Each month, it buys near-term futures contracts–which best approximate the spot price of oil–and then a week or two prior to expiration, sells them and simultaneously uses these funds to buy the next month’s contracts, thereby avoiding taking physical deliver of more than $2 billion worth of oil (or 40 million barrels) and maintaining constant exposure to the commodity. For this service, the fund charges an annual fee of around 0.7%. However, this process of buying and selling contracts is not without it complications. More on this in a moment. After witnessing the popularity of USO and its cousin the US Natural Gas Fund (NYSEARCA: UNG ), other ETF companies were quick to jump on the bandwagon with increasingly innovative and volatile products. In late 2008, ProShares upped the ante and introduced the Ultra Bloomberg Crude Oil ETF (NYSEARCA: UCO ), which utilized leverage to deliver 2x the daily movement of oil. That is, if oil (and USO) gained 2% in a day, UCO would gain 4%, and if oil lost 2%, UCO would lose 4%. Unsurprisingly, this product was embraced by daytraders due to the enhanced volatility that is their lifeblood. However, it was also traded by longer-term traders looking to capitalize on a prolonged rally in crude oil. Like clockwork, 4 years later in late 2012, the company VelocityShares decided that 2x volatility just wasn’t cutting it and released the exceptionally volatile VelocityShares 3x Long Oil ETF (NYSEARCA: UWTI ). As its name suggests, this ETF was designed to move 3x the daily price of oil. Despite their differences in leverage, all three products work similarly in that they buy futures contracts and roll them over each month, aiming to track the price of oil on a daily basis. That being said, the devil is in the details–and the interworkings of these ETFs have a lot of details that dictate whether these ETFs are effective in accurately tracking the price of oil. Let’s start simple. Figure 1 plots the price of oil versus the price of USO since its inception in April 2006. (click to enlarge) Figure 1: Crude Oil versus USO since inception in 2006, showing underperformance of ETF versus its underlying commodity Data source: Yahoo Finance; c hart created by author. Conveniently, both began the period at nearly identical prices of $68 per share or per barrel. Since then, oil has slid to $46/barrel as of September 22, 2015 while USO has slid much steeper to just $15/share. What explains this underperformance? While the previously discussed process by which USO rolls over its futures contracts each month guarantees continuous exposure to oil, it is not without its drawbacks. Were subsequent futures contracts equally priced, it would not be an issue. The fund would sell X number of soon-to-expire contracts and use these funds to buy X number of next-month contracts. However, futures contracts of commodities such as oil frequently trade in a structure known as contango where later contracts are more expensive than near contracts. This is understandable, particularly after oil has taken a large fall, that investors expect prices to rebound in the long term as uncertainty increases. Unfortunately for funds such as USO, this means that each month the fund is selling X number of contracts and buying X-Y number of contracts. Effectively, the fund is selling low and buying high. And as contango can routinely reach 1-2% per month during periods of wide contango, the fund sees a price-independent degradation of roughly this percentage. While this is relatively minor in the short term, it adds up and can be relatively devastating for long term holders, as seen in Figure 1. What about UCO and UWTI? Figure 2 below plots the performance of oil versus USO versus UCO versus UWTI since December 10, 2008. 2008 was used as it encompasses the full history of both USO and UCO. The price history of UWTI from 2008 to 2012–when it debuted–was reconstructed based on price history of USO and UCO. (click to enlarge) Figure 2: Crude Oil versus USO, UCO, and UWTI since 2008, showing massive underperformance of leveraged ETFs versus USO and crude oil Data source: Yahoo Finance; c hart created by author. If USO “underperformed,” then UCO and UWTI were decimated. UWTI dropped 99.3% from an estimated $1841 per share to just $11 per share while UCO dropped 92% despite oil squeaking out a 5% gain. This dramatic underperformance versus both oil and USO occurred for two reasons. First, the impacts of rollover discussed above are compounded due to leverage. If the monthly contango in the futures market is 2%, the attributable loss increases to 4% for UCO and 6% for UWTI, which adds up very quickly. Second, due to the leveraging process a phenomenon known as “leverage-induced decay” also weighs on performance. I will spare you all the math, but suffice to say, large moves in one direction followed by sharp reversals leads to under-performance of leveraged ETFs independent of the effects of contango. What does this mean for oil traders? Figure 3 below uses the data in Figure 1 and 2 above to calculate average, expected underperformance versus the price of oil sustained from holding USO, UCO, and UWTI over a yearlong period. Overall, 2000 different 1-year periods are used to generate this data (click to enlarge) Figure 3: Expected underperformance of USO, UCO, and UWTI based on the number of days the ETF is held, from 2008-2015 data Data source: Yahoo Finance; c hart created by author. A 22-day hold in USO is predicted to result in a 1% underperformance versus oil. That is, if oil gains 5% during this period, the ETF would be predicted to yield around 4%. On the other hand, it would take just 9 days to reach a 1% underperformance holding UCO and a mere 6 days to see a 1% underperformance holding UWTI. Over a typical year-long period, USO is expected to underperform by 10.9% compared to 22.2% for UCO and 37.4% for UWTI. It should be noted that the underperformances for UCO and especially UWTI are somewhat deceptive and in many cases may actually be much lower. For UWTI, when oil falls greater than 33.3% in a year, UWTI will inevitably “outperform” oil given that it cannot fall more than its predicted 100%, which skews the mean underperformances shown in Figure 3 to the upside. However, when sitting on an 80-90% loss, I expect any such “outpeformance” feels rather pyrrhic. Based on this analysis, it is clear that USO outperforms UCO and UWTI and comes the closest to accurately tracking the price of oil. UCO and UWTI have their uses among the day-traders and swingtraders, but should not be used as investment tools as the long-term drawdown is simply too great to justify its use. Sure, should oil double in a year, the 37% underperformance is acceptable given the predicted 300% gain, but if oil is flat on the year–which occurs much more frequently than that edge case–you are sitting on an inexcusable loss. Of the 3 ETFs, USO offers the best risk/reward profile and, in my opinion, is the superior product and the only one that should be considered for long-term investors. So far, I’ve limited this discussion to popular commodity ETFs that are designed to mimic the spot price of oil–so-called “pure oil” ETFs. As discussed, the big drawback of these products is that you CAN’T mimic the spot price of oil, not over the long term. Let’s now consider oil companies themselves. Major producing companies derive a substantial portion–if not all–of their income from oil sales. Therefore their share prices should be closely tied to the price of oil. The advantage of oil stocks over pure oil ETFs, of course, is that they are not subject to the same rollover losses as USO. If it can be determined that oil companies effectively track the price of oil on a day-to-day basis, it can be expected that they would do so over the long-term and not be subject to decay. Rather than analyze individual companies whose stocks are intermittently subject to forces not directly related to the price of oil such as earnings reports, lawsuits, and legislation, let’s instead consider a basket of oil companies to smooth out these events i.e. the oil sector ETFs. The 3 most popular oil sector ETFs are the Energy Select Sector SPDR (NYSEARCA: XLE ), the MarketVectors Oil Services ETF (NYSEARCA: OIH ), and the SPDR S&P Oil & Gas Exploration ETF (NYSEARCA: XOP ). XLE’s diverse holdings include large cap oil companies involved in all aspects of the petroleum industry such as Exxon Mobil (NYSE: XOM ), Chevron (NYSE: CVX ), and Schlumberger (NYSE: SLB ). OIH’s largest holdings, on the other hand, are more focused on oil service companies alone and include SLB, Halluburton (NYSE: HAL ), and Baker Hughes (NYSE: BHI ). Finally, XOP’s largest holdings include major exploration companies such as HollyFrontier (NYSE: HFC ), PBF Energy (NYSE: PBF ), and CVR Energy (NYSEMKT: CVR ). Figure 4 below plots the performance of each versus Oil and USO since 2009. (click to enlarge) Figure 4: Crude oil versus select oil sector ETFs Data source: Yahoo Finance; c hart created by author. Notice that the price of oil tends to form the upper bounds of this chart while USO forms the lower bounds with the 3 oil sector ETFs somewhere in between. Of the 3, XLE seems to be the best, handily outperforming both oil and USO over the 10 year period. This suggests that the oil sector ETFs are superior to USO in their ability to track oil without price-independent losses, as predicted. However, the key concept is correlation. Apple Computer (NASDAQ: AAPL ) has certainly outperformed oil and USO over the past decade as well, but given none of its businesses are related to oil, it has no correlation to the petroleum industry and is not a useful analogue. Correlation can be determined by looking at beta and the R-squared value. Figure 5 below shows a scatterplot between the daily percent change of the price of oil versus USO and XLE. (click to enlarge) Figure 5: Scatterplot comparing the daily percent performance of crude oil versus XLE and crude oil versus USO, showing a tighter correlation between oil and USO Data source: Yahoo Finance; c hart created by author. It can be easily appreciated that oil vs USO (the red dots) forms a tighter linear relationship than oil vs XLE (the blue dots), which is much more diffuse. Further, notice that the slope of the oil vs USO relationship is closer to 1:1 on the x- and y- axes while the oil vs XLE relationship is flatter. This illustrates the twin concepts of correlation and beta, respectively. Correlation is the idea that two entities are related. If entity A moves a certain magnitude, entity B moves a predictable magnitude in response. However, it does not have to be 1:1. For example, for every 10% that A moves, entity B might move 25%. Predictable, but not equal. Correlation is measured by the R-Sq value. In finance, beta is traditionally thought of as a measure of the volatility of a security or portfolio in comparison to the market as a whole. A stock with a beta of 1.0 indicates that a stock’s price movement will mimic that of the market – if the S&P 500 gains 5%, the stock will gain 5%; if the market is flat, the stock will be flat; and if the market falls 5%, the stock will fall 5%. A stock with a beta of 2 is more volatile than the market – a tech stock, for example – and will gain or lose twice that of the S&P 500 or whatever index is used as the benchmark. A beta of 0.5 is comparatively less volatile – a utilities stock, for example – and will gain or lose half of the market’s performance. While the beta is typically applied to compare a stock to a market or index it is a relatively simple calculation and can be used to compare any two equities or funds against each other. Equation 1 below shows the equation used to calculate beta: Equation 1: Beta = Covariance (Daily % Chg stock for which beta is being calculated, Daily % Chg underlying index)/Variance (Daily $ Chg Underlying index) In this case, we will be comparing the price of oil versus each of our ETFs. An ETF with a beta of 1.0 means that the ETF tracks oil on a 1:1 basis on a daily basis. Figure 6 below shows the R-Sq and beta values for USO, XLE, OIH, and XOP compared to oil. (click to enlarge) Figure 6: Betas and R-Sq values for USO, XLE, OIH, and XOP showing USO trumps the 3 oil sector ETFs by a large margin Data source: Yahoo Finance; chart created by author. Again, USO comes out on top in both categories. USO’s R-Squared with oil is 0.81, handily beating XOP which comes in second with an RSQ of 0.57 while its beta is 0.80, crushing XOP’s 0.43. Thus, while all three oil sector ETFs may outperform USO, they do so due to factors not directly related to the price of oil. This article is not about picking good investments. It is about selecting the ETF that best accomplishes a certain objective: to track the price of oil accurately over the short and long term. In conclusion, this analysis of several popular oil ETFs has determined that the United States Oil Fund is the best long-term investment in terms of accurately tracking the price of oil as well as minimizing losses due to futures contract rollover. That is not to say that the other ETFs might not have niche uses. UWTI and UCO are certainly effective trading vehicles for those trying to capitalize on an oversold bounce or socioeconomic-driven event over 3-5 days. Likewise, XOP, XLE, and OIH may be superior to USO for super-long terms investors with a Warren Buffet-like mindset who plan to hold for well-over 2 years and care more about historical performance than accuracy in tracking an underlying commodity. However, for the typical investor who is looking to capitalize on a steady rise in oil prices from a week to 2 years or so, I firmly believe the USO is the most effective trading vehicle to do so.

Understanding Your MLP’s Financially-Engineered Equity Value

Summary Let’s cover some ground, some of it new, some of it old, but all of it worth repeating. In this article, we will synthetically create the equivalent of a master limited partnership (MLP), called iNewCorp with Kinder Morgan’s financial profile, from scratch with effectively no capital at all. We’ll address the rumor mill by showing how the oil and gas pipeline industry is not covering its dividend and distribution payments with traditional free cash flow, a valuation term. We’ll also explain how valuation techniques cannot ignore growth capital in the valuation equation of MLPs (AMLP) or other midstream corporates. The primary goal of this piece is to reveal how warped the financial engineering has become with respect to MLPs, especially in the context of the “valuations” placed on them. (click to enlarge) For background on this topic, please read “5 Reasons Why Kinder Morgan Will Collapse,” and “5 More Reasons Why Kinder Morgan Will Collapse.” In this article, we will synthetically create the equivalent of a master limited partnership (MLP), called iNewCorp with Kinder Morgan’s financial profile, from scratch with effectively no capital at all, with only a strong credit rating. In such an example, we’ll also explain how valuation techniques cannot ignore growth capital in the valuation equation of MLPs (NYSEARCA: AMLP ) or other midstream corporates by pricing them on a multiple of “distributable cash flow” or on the dividend/distribution that follows it. We’ll do so by contemplating the value of a company that has a “distributable cash flow” stream requiring maintenance (and/or growth) capex versus one with the same “distributable cash flow” stream not requiring any maintenance (and/or growth) capex. First, however, we’ll address the rumor mill by showing how the oil and gas pipeline industry is not covering its dividend and distribution payments with traditional free cash flow, a valuation term, which differs from the industry’s definition of ‘distributable cash flow,’ a contractual term–not one to be used in valuing equities, or at least in the context of how some are using it. The primary goal of this piece, however, is to reveal how warped the financial engineering has become with respect to MLPs, especially in the context of the “valuations” placed on them. When one sees how easily other corporates such as Apple (NASDAQ: AAPL ), Microsoft (NASDAQ: MSFT ), Cisco (NASDAQ: CSCO ), or Qualcomm (NASDAQ: QCOM ) or any other entity with excess cash and a strong credit rating can create a shell conduit that is priced on a contractual pass-through to shareholders, or the substance of the distribution pass-through to unitholders of an MLP, for example, either one of two things may happen: 1) every capable company will or should create cash-flow-backed shell companies to artificially generate value at the parent, consequences unknown or 2) the MLP business model will be restrained, or dissolved in time. In the example to follow, we’ll show how an investment-grade company, with essentially no investment or ongoing commitment at all, can generate $120 billion in incremental equity value, to the tune of the equivalent of the entire enterprise value of Kinder Morgan (NYSE: KMI ), at the time the example was originally developed. Given the recent controversial, contractual pass-through structure of Alibaba (NYSE: BABA ), for example, we wouldn’t be surprised that, if board rooms in other sectors, namely technology, knew how easily value could be generated in the following way, we’d see cash-flow-backed shell companies expand in number just the same as the MLP model has proliferated across the energy complex in the US. But first, let’s clear the air. The Shocking Truth About the Free Cash Flow Shortfall and Debt Bubble Most master limited partnerships and midstream corporates do not generate enough traditional free cash flow to cover their cash distributions and dividends. Anything to the contrary is categorically false. A look at traditional free cash flow generation, as measured by cash flow from operations less all capital spending, after distributions/dividends for a select, but large and representative group of upstream and pipeline MLP plays, shows a massive shortfall. The select group of entities in the table at the top of this article, both upstream and midstream, had an aggregate $16.7 billion free cash flow shortfall relative to cash dividends paid during the first half of 2015 as they collectively held a staggering $210 billion in net debt at the end of the second quarter of 2015; that’s nearly a quarter trillion dollars! The idea that such financial profiles can possibly translate into a view that their dividends/distributions are “safe” is hard to believe. What’s more, how some of the debt from entities in this group can be considered investment-grade by the rating agencies when such entities have been unable to generate operating cash flow in excess of total capital spending and the dividend/distribution, and in light of their “junk-equivalent” net debt to adjusted EBITDA levels, is even harder to believe. It may be the nature of the MLP business model that Is causing this ominous dynamic, but it may not be, but it may not matter either . A corporate, not MLP, Kinder Morgan , for one, has the choice to finance all of its capital expenditures with internally-generated cash flow from operations and forgo the current level of its dividend, as most corporates do, but it doesn’t. Instead, Kinder Morgan accesses the debt and equity markets, not for funds related to capex because we argue it already has them (the firm has already generated them in cash flow from operations), but because it wants to keep paying and growing a dividend. There’s nothing wrong with this, per se, unless of course, investors are led to believe that the dividend is organically-derived like those of other corporates, which pay out their dividends as a percentage of earnings and/or traditional free cash flow. In 2015, Kinder Morgan will pay out twice as much in cash dividends than it will generate in earnings and possibly four times as much in dividends as it will generate in traditional free cash flow. From our perspective, and Kinder Morgan’s activity sheds light on this, executive teams across the MLP space are also, in substance, accessing the equity and debt markets as a way to fund distributions, and in our view, conveniently using the MLP structure as a way to do so, helping to facilitate a debt-infused dividend-based equity pricing paradigm. It doesn’t matter if this is “how MLPs work” or not, this is what’s happening at the core. Internally-generated capital is always the lowest cost of capital – and that it is not being used as the primary source of investment for growth, even for a corporate pipeline operator, which has as much flexibility as any other corporate, is a significant red flag, at the very least. Investors should continue to be concerned about debt-infused dividends/distributions and the equity pricing structure that surrounds them. Understanding the Financial Engineering of MLPs and Why Traditional MLP Valuation Techniques Should Not Omit Growth Capex The following example is purely hypothetical and for educational purposes only, but let’s explain, for example, how Apple–a balance-sheet cash-rich entity–can effectively financially engineer a completely new entity that has “Kinder Morgan’s” current financial profile, or create ~$75 billion in incremental equity value or more, using less than 5% of Apple’s current balance sheet, or arguably with nothing at all. (Note: Kinder Morgan had been trading at a higher price level when this example was first developed, so its market-related information is not current.) First, let’s cover some financials. Kinder Morgan, the largest energy infrastructure company in North America, is on pace to generate ~$4.5 billion in “distributable cash flow” in 2015. Traditional free cash flow, however, will be substantially less than “distributable cash flow” during the year given growth capital investments that are necessary to drive future increases in net income, a component of future “distributable cash flow.” This is a very important point that will be critical later in this example. Let’s assume that Kinder Morgan’s “distributable cash flow” will advance at a ~10% clip over the next few years, in line with management’s expectation for the pace of dividend growth over the same time frame. Kinder Morgan’s enterprise value is currently ~$120 billion, consisting of about $75 billion in equity and $45 billion in debt (at the time the example had been written). Apple holds over $200 billion in cash, cash equivalents and marketable securities on its balance sheet, as of June 27, 2015. For illustration purposes, let’s have Apple create a corporation called iNewCorp, in which it sets up a partnership agreement by which Apple contributes ~$4.5 billion, more or less, in cash to iNewCorp per annum in exchange for 100% ownership of iNewCorp. The agreement stipulates no minimum distributable-cash-flow to dividends-paid ratio, meaning that dividends can exceed Apple’s cash contributions at any time, which equivalently happens periodically across the master-limited-partnership arena when distributions exceed distributable cash flow in certain periods. From a baseline of ~$4.5 billion, let’s also assume that iNewCorp plans to increase dividends to its future shareholders by 10% each year through 2020 and by a more-reasonable growth rate after that. The initial ~$4.5 billion “start-up” obligation could easily be covered by Apple, an entity with $200 billion on the books and one that has generated ~$68 billion in cash flow from operations during the nine months ending June 27. Apple can cover the initial ~$4.5 billion obligation 40+ times over with cash on the balance sheet and 15+ times over with nine-months-worth of cash from operations. Let’s now assume that Apple guarantees iNewCorp’s growing dividend stream and any and all of iNewCorp’s debts, thereby giving iNewCorp an investment-grade credit rating. With such an investment-grade rating, iNewCorp then borrows ~$45 billion against the future cash flow stream that is implicitly backed by Apple, coincidentally approximating Kinder Morgan’s debt outstanding. If you think this is good thus far, it gets better. iNewCorp then uses this $45 billion in newly-raised debt to backstop its very own future dividend payments to its very own future shareholders. With the newly-raised debt alone, iNewCorp would then be able to cover growing dividends to its future shareholders for ~5-10 years depending on the growth rate, without any future Apple cash contributions. Apple now IPO’s iNewCorp. iNewCorp can now raise equity on the open market such that, with its newly-raised debt, the corporate is now able to fund its entire growing dividend stream via external capital-raising efforts, maybe on a 50%/50% equity/debt split if it wants to. Said differently, iNewCorp can fund its entire future and growing dividend stream purely from financing activities. Under this scenario, to sustain iNewCorp’s dividend, Apple itself would not have to pay any more ongoing cash to iNewCorp after the initial ~$4.5 billion outlay. Since there is no minimum distributable-cash-flow to dividends-paid mandate within this particular partnership agreement, Apple would only have to stand as a backdrop and guarantee the newly-created entity’s future dividends and debt load. The external financing markets are sustaining the dividend. What Apple has done in this example is financially engineer the future dividend stream and capital structure of a new “Kinder Morgan,” which we have called iNewCorp, and it has done so with effectively no capital at all. Apple is just standing behind iNewCorp reinforcing its investment-grade borrowing capacity, which supports the dividend that supports the equity price, which provides incremental equity capital that can also be used to support iNewCorp’s dividend, and so on. On the basis of the current enterprise value of the actual Kinder Morgan, iNewCorp should theoretically fetch an enterprise value of at least $120 billion (or it was at the time), which would be all equity in iNewCorp’s case, until borrowings are distributed to iNewCorp’s shareholders as dividends. If dividends should happen to be paid directly from newly-issued equity, then there’s no reason to believe iNewCorp’s equity wouldn’t hold a ~$120 billion equity price, all else equal (at least in this market). There’s more that meets the eye, however, and this is where it becomes clear that growth capital cannot be ignored in the valuation of oil and gas pipeline entities. (Please note that given recent changes in the market price, Kinder Morgan’s price-to-distributable cash flow ratio has fallen significantly from noted levels below). Kinder Morgan has been trading at a price to distributable cash flow ratio of ~16.5 times (a ~6% distribution yield, or it had at the time), and some may argue the enterprise value and equity market capitalization of iNewCorp should theoretically be higher than Kinder Morgan’s. After all, Kinder Morgan requires maintenance and growth capital to fuel future net income and dividend growth and has exposure to commodity price shifts and other operating risks, while iNewCorp does not. Apple’s newly-created corporation is pure and growing cash. In our view, however, iNewCorp should be the one to fetch a ~16.5 times price-to-distributable multiple (~6% distribution yield), while Kinder Morgan’s price-to-distributable cash flow ratio should be substantially lower given commodity and operating risks as well as the maintenance capex and massive growth capex that is required to drive future net income expansion. They both can’t have the same price-to-distributable cash flow ratios just because their distributable cash flow is the same-one requires significant cash outflows to sustain the payout while the other requires none. In the example of iNewCorp, valuing different equities with varying growth capital outlays and commodity/operating risks on a standardized price-to-distributable cash flow ratio is fraught with inconsistencies and imbalances. Furthermore, in this hypothetical example, with less than 5% of its balance sheet or with perhaps nothing at all, Apple has created in iNewCorp ~$120 billion in incremental equity value, or a ~20% boost to Apple’s entire market capitalization (Apple would have received the proceeds from the IPO of iNewCorp or retained an ownership stake). That’s certainly a needle-mover for one of the largest companies in the world! One may even say that Apple can easily cover an arrangement like this many times over. If you believe in the financial engineering above, then theoretically Apple can create trillions of equity capitalization repeating this over and over again. Apple’s balance sheet and cash flow generation are assets much like the pipelines in the ground are assets. There is a very good reason, in our view, why dividends should be paid out of traditional free cash flow (cash from operations less all capital spending) or earnings, as anything else is textbook financial engineering and arguably misleading to the individual investor that believes all dividends/distributions are created equal, which they are not. We’re sticking with companies that have organically-derived dividends, and we’re not omitting varying growth capital outlays and operating risks from our analysis.