Playing Commodities Through Exploration ETFs

by on November 17, 2010 | ETFs Mentioned:

As the dollar continues to suffer from a crisis of confidence and emerging markets continue to display insatiable appetites for raw materials, commodities have become one of the best performing asset classes of the year. Several remarkable rallies have spurred an exodus of investor assets to commodity markets, which have a history of offering investors protection against inflation and thriving as the dollar weakens. Both anxiety over the future of the dollar and optimism over growing demand from emerging markets has pushed several commodities to new highs; gold has repeatedly closed at record levels, and oil has regained momentum despite weakness in many developed economies. Beyond these widely-traded commodities, a number of other resources have surged as well in recent months, including cotton, copper, and silver.

Many investors looking to establish exposure to natural resource prices have embraced commodity ETFs, including both broad-based and commodity-specific funds. While many investors have cheered the arrival of commodity ETFs as a way to potentially add non-correlated assets to traditional stock-and-bond portfolios, others have expressed some frustration over their performance. Because many commodity ETPs utilize futures-based strategies, the returns to these funds depend not only on movements in spot prices, but also the extent to which futures markets are contangoed or backwardated. That means that significant gaps can (and often do) arise between a hypothetical return on the spot price of a commodity and the actual return delivered by an ETF linked to that asset.

As a contango-free alternative to commodity exposure, many investors have turned to ETFs that invest in stocks of commodity-related companies–betting on copper through stocks of copper miners or timber prices through timber companies. Because the profitability of these companies depends on the market price for the related natural resources, there will generally be a strong correlation to movements in the value of the commodity.

Most of the products in the Commodity Producers Equities ETFdb Category focus on companies that produce or produce natural resources, such as the ultra-popular Gold Miners ETF (GDX) or broad-based Hard Assets Producers ETF (HAP). But there are also a handful of ETFs that focus on an earlier stage in the production process, investing in companies whose operations focus around exploring for new reserves. With many commodity prices at near-record levels and demand from emerging markets still climbing, uncovering new reserves has become a critical aspect of the global natural resources industry. Many mines and oilfields have been tapped out due to decades of operations, making the exploration business a potentially lucrative field.

But exploration is also an inherently risky business, as even well-run companies may fail to come across new deposits, and even investors with significant time and expertise will struggle to predict which companies will strike it rich and which will be forced to fold. As such, efficient diversification across multiple companies–provided in a cost-efficient manner by ETFs–is particularly valuable in this more speculative corner of the market. Below we highlight three ETFs offering exposure to exploration companies:

SPDR S&P Oil & Gas Exploration & Production Fund (XOP)

For investors seeking exposure to oil and gas exploration firms, XOP is an interesting option. This fund tracks the S&P Oil & Gas Exploration & Production Select Industry Index, an equal weighted benchmark consisting of companies whose operations focus on exploration and production of oil and gas. While some of the index components are smaller firms, XOP also includes some big names; ConocoPhillips, Apache Corporation, and Anadarko Petroleum are among the largest allocations. So far in 2010, XOP has performed reasonably well, posting a gain of almost 15% year-to-date [see Three Rock Solid Energy ETFs].

Global X Gold Explorers ETF (GLDX)

GLDX tracks the Solactive Global Gold Explorers Index, an index that consists of companies active in the gold mining industry as explorers. The fund invests in 30 securities in total with heavy exposure to North American markets, which make up close to 88% of the total assets. In terms of individual holdings, Detour Gold, European Goldfields and Novagold are among the largest.

Many of the components of GLDX are generate negative cash flows, and are hoping to literally strike gold through exploration of various projects. As significant discoveries of new gold reserves have become increasingly rare in recent years, companies that uncover valuable accessible deposits can see their outlooks improve dramatically. This fund could be appealing to investors interested in accessing the potentially high returns generated through exposure to gold explorers, but without the time, knowledge, or risk tolerance to select individual exploration companies [also read Global X Launches Gold Explorers ETF].

Jefferies CRB Wildcatters Exploration & Production Equity ETF (WCAT)

This ETF also focuses on companies engaged in the exploration and production of energy commodities, but is very different from XOP. WCAT maintains a heavy tilt towards smaller, more speculative companies, while XOP’s components tend to be established firms. Moreover, WCAT’s holdings are engaged more heavily in the exploration side of the business, while XOP components are more likely to focus on production of oil and gas from proven reserves [also see WCAT: Another Alternative To UNG].

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Disclosure: No positions at time of writing.