IndexIQ rolled out the latest ETF offering exposure to oil companies today, debuting the IQ Global Oil Small Cap ETF (IOIL). The new ETF will be the first exchange-traded product to offer exposure to global small cap companies engaged in the oil sector, including areas of exploration and production, refining and marketing, and equipment, services and drilling. IOIL will seek to replicate the IQ Global Oil Small Cap Index, a benchmark that consists of about 60 small cap oil companies from more than a dozen emerging and developed economies.
Oil refining and marketing stocks account for about 40% of the underlying benchmarks, with exploration and production firms making up 37% or so and the remainder attributable to equipment, services, and drilling firms. Stocks listed on U.S. exchanges account for about 45% of total assets, with Canada, Thailand, Colombia, and Japan making up the most significant international allocations.
New Twist On Oil Investing
Interest in companies engaged in the discovery and extraction of oil has increased in recent months as prices of WTI and Brent crude oil have climbed steadily higher. Because the profitability of oil companies generally depends on market prices, the value of oil-intensive companies often exhibits a strong correlation to spot oil prices. Investors have no shortage of ETF options for accessing oil companies; IOIL is the 26th ETF in the Energy Equities ETFdb Category, but offers exposure that is unique from many of the existing products. The most popular energy ETFs focus on “Big Oil,” or large multi-national firms that have established operations, significant proven reserves, and projects around the globe. The Energy SPDR (XLE), for example, consists almost entirely of giant and large cap stocks, with Exxon and Chevron accounting for about 30% of total assets [compare XLE and IOIL here].
Small cap oil companies can offer complementary exposure to Big Oil, delivering a way to access companies that focus on discovering new oil reserves and servicing drilling operations maintained by large cap companies. The holdings of IOIL will be relative unknowns to most investors; Sunoco, Oceaneering International, and Core Laboratories are among the largest allocations.
While small cap companies may be effective in rounding out exposure to the energy sector, they may also be useful for avoiding an unclear regulatory environment. On the day IOIL launches, House Democrats will reportedly force a vote on a measure that would eliminate tax breaks for the oil industry while bringing a bill to expand domestic drilling to the floor. While some measures may effect the oil industry from top to bottom, other proposals are specifically targeted at the largest oil companies. Small cap oil companies, particularly those outside of the U.S., may not feature the same degree of scrutiny and public backlash that the Exxons and BPs of the world face in the current environment [Uncertain Future For Energy ETFs].
Besides minimizing the political risk that has intensified in the U.S., there are other reasons why achieving exposure to the energy sector on a global basis may be appealing. The international energy sector has seen revenues grow at a rate nearly twice that of the U.S. sector over the last decade. And that trend is expected to continue going forward, as growth in demand from emerging markets is expected to significantly outpace and increases from the U.S. and other developed markets. By some estimates, emerging markets energy demand will increase by close to 85% by 2035, compared to less than 15% for developed economies.
Many large cap U.S. energy companies, such as Exxon and Chevron, have significant overseas operations, and as such are positioned to benefit from increased international demand for emerging markets. But in many instances, local firms will be better positioned to exploit the opportunities created by this demand growth, thanks to regulatory hurdles and other legal obstacles.
While most energy products focus on U.S. stocks, there are a few existing ETFs that offer international energy ETFs, including the iShares S&P Global Energy Index Fund (IXC). That fund consists almost entirely of giant cap and large cap stocks, and has virtually no overlap with the new IndexIQ fund.
Small Cap Focus
Small cap stocks have historically performed quite well in terms of delivering exposure to spot oil–often tracking the commodity more closely than even futures contracts. And there are a number of reasons why small cap energy companies may be positioned to perform well relative to their large cap counterparts. Emerging markets account for an increasing percentage of global energy use, thanks in large part to skyrocketing car ownership rates and ongoing urbanization. Smaller, local refining companies could benefit primarily from that trend. Moreover, discoveries of massive reserves have dropped off in recent years; new additions to global supplies are coming in the form of singles and doubles, not home runs. As a result, smaller exploration and production companies are able to capture a greater amount of new oil.
Exposure to exploration and production companies can also offer exposure to a unique corner of the energy market. Firms engaged in the search of new oil reserves have the potential to strike “black gold,” meaning they will generally maintain significant upside potential. While there are a number of exploration and production ETFs already available, existing products are generally light on exposure to small cap companies. In addition, ETFs such as XOP or IEO focus almost exclusively on U.S. stocks, while IOIL will maintain a more global focus [see Energy ETFs: Global Or U.S.?].
IOIL will charge an expense ratio of 0.75%.
Disclosure: No positions at time of writing.