Oil producers continued pumping despite an oil demand slowdown in the first quarter of 2014, possibly under the assumption that slightly lower prices would increase consumption. At the same time, the markets presumed, based on standard economic theory, that producers would reduce their output to bring the supply and demand equation back in line. Both assumptions proved to be wrong, and by February 2016, the price of oil had dropped into the low $30s, a level not seen since June 2004.
As the calls for contrarian oil investments make the rounds, investors can choose from a wide range of ETFs with moderate to extreme risk thresholds. ETFs with moderate risk are generally composed of large-cap stocks that can withstand low oil prices for as long as necessary, such as
Chevron Corp. (NYSE: CVX), Exxon Mobil Corp. (NYSE: XOM) and ConocoPhillips Co. (NYSE: COP). On the other hand, the ETFs posing the highest risks are characterized by holdings focused on exploration, companies carrying high debt levels, or those with a leveraged fund structure. The following are the three riskiest oil ETFs for 2016.
Market Vectors Unconventional Oil & Gas ETF
The Market Vectors Unconventional Oil & Gas ETF (NYSEARCA: FRAK) tracks the performance of companies that use non-traditional means of producing, extracting and refining oil, which gives the fund exposure to exploration companies focused on shale oil and the use of fracking extraction technologies. Technology and deal-making have brought the average break-even price of producing shale oil down from $65 to $50, but that is still a big loss on every barrel.
The negative gap between the production cost and the price of oil results in two distinct challenges for unconventional oil and gas companies. First, smaller companies typically go into debt to start and expand drilling and extraction processes. Servicing this debt requires cash flow, which forces companies to continue producing oil, even if there are losses on every barrel. The second challenge is the relatively short life of shale oil wells. The production from these wells drops by an average 50 to 70% by the end of the first year, forcing companies to continually replace lost production with new wells.
Constant drilling expenses are one of the main reasons for the 42 bankruptcies filed by oil companies in 2015. The lower prices seen in 2016 will likely increase the financial pressure on many of the companies held by the Market Vectors Unconventional Oil & Gas ETF.
VelocityShares 3x Long Crude Oil ETN
The leverage of the VelocityShares 3x Long Crude Oil ETN (NYSEARCA: UWTI) gives the ETF approximately 10 times the volatility of the S&P 500. Leverage is achieved through the use of long front-month futures contracts on West Texas Intermediate (WTI) oil, which are rolled forward to the following month prior to expiration.
The fund also carries counter-party risk because it is actually a note with payment based on the ability of Credit Suisse to cover the fund’s obligations. However, this issue is much less a concern than the fund’s performance in a falling market. The volatility, combined with the drop in oil prices, resulted in a one-year loss of 94.56%, as of Feb. 24, 2016. Should oil prices continue to fall, the fund's leverage could deliver a repeat performance over 2016.
VelocityShares 3x Inverse Crude Oil ETN
Extreme risk in oil ETFs are present in a rising price environment, as well. The VelocityShares 3x Inverse Crude Oil ETN (NYSEARCA: DWTI) provides the same level of volatility as the fund family’s leveraged long ETF, with triple leverage on the short side of WTI futures. Its heavy leverage, combined with being right on the direction of oil prices, resulted in a 3-year annualized return of 77.4%, as of Feb. 24, 2016.
Anyone tempted to chase these returns should stop and reconsider. To find the reason for pause, look no further than the fund's performance in this falling market. Being leveraged and short during a strong move higher in oil prices could wipe out the share value in the same way.
The Bottom Line
Risk and opportunity go hand in hand. However, high break-even prices for shale oil may keep pressure on related companies, even if oil prices stage a strong rally. Extreme price volatility is likely in leveraged funds, regardless of the direction of oil prices. These funds are suitable for only the most risk-tolerant investors and speculators.