Risk, Oil and ETFs

The title suggests three things currently on my mind in relation to our investments. They are related. I will begin with oil. My top expert on the secular commodity bull market is Jim Rogers. His media appearances and books (especially Hot Commodities) are the main reason commodities have been the foundation of my portfolio since 1999.

In 1998, Rogers created the Rogers International Commodity Index (RICI). Although there are 36 different commodities in the index, he has them divided into three broad categories as follows:

• 44% energy (including 35% crude oil, and 9% natural gas & gasoline)
• 35% agricultural
• 21% metals

Think about this for a moment. If I decide I want 50% of my portfolio in physical commodities, and I want to follow Rogers' energy allocation, I will need to have 22% of my entire portfolio in energy, including 17.5% in crude oil, and 4.5% in natural gas or gasoline. (I'm currently 10.9% physical energy). There is a message in this. Rogers considers oil to be the single most important commodity on earth, with the best potential for gain, thus, in his opinion, it should be the largest holding in a commodity portfolio. His reasons are simple. In a word, supply and demand. There hasn’t been a major new oil discovery in 40 years. Production has reached a peak (opinion of several experts), and will begin to decline, while world demand is rising rapidly.

On March 25, in an interview on CNBC, Boone Pickens confirmed this thesis. He said, “The major oil companies have peaked on their production. They are in liquidation. They can't add to their reserve base or production.”

If you are interested in learning more on this subject, I highly recommend the documentary, A Crude Awakening. It is available on DVD from rental sources such as Netflix.  To order your own copy from Docurama, click here.  (A 2-minute trailer is also available on YouTube.)

There is no question in my mind that oil should be an important holding in my commodity portfolio. That leads to the question, what is the best way of holding it. Other than owning interests in oil producing properties, I know of only three ways to invest in oil, oil company stocks, oil futures contracts, and oil ETFs (exchange traded funds). 

During the early years of the commodity bull market (2000 to 2005), when I was investing for myself and a group of other investors, we invested in 3 or 4 blue chip oil company stocks. This served us well. But as I studied Rogers, I kept hearing him say that studies show that investing in the actual commodity consistently produced significantly higher returns than investing in the stocks of companies that produce the commodities. (I have quoted these sources in past letters, so I won't repeat them here). Rogers has the majority of his commodity investments in the futures markets (more detail below). He does admit to having a small portion in oil stocks, but he has all his stock holdings hedged (also explained in past letters).

So, what about using oil and gas futures for our energy investing? My conviction is that the futures market is no place for the average investor. It is high risk, unpredictable, volatile and dangerous. It involves the use of margin, a code word for borrowed money, and unless the borrowed money (market value of the commodities minus the margin deposit put up) is a small percent of ones net worth, it is way too risky in my opinion. I have (for the first time in 35 years) invested a small percent in commodity futures. Some of you may be experts in this area, and may wish to take the risk, but I cannot in good conscience recommend it, and I am growing more uncomfortable with it as time passes, and plan to phase it out. That brings me to the subject of ETFs.

I have been looking forward to the creation of exchange traded funds which make it easy for the average investor to own a physical commodity in an amount he can afford, or a diversified portfolio of several different commodities, without having to buy futures contracts, and meet margin calls. Well, now we have them. Quite a few of them have come out over the past year. To my knowledge, we can now buy oil (United States Oil Fund Lp, symbol USO), gas (United States Natl Gas Fund, symbol UNG), or a group of agricultural commodities (iPath Dow Jones-AIG Agriculture Total Return Sub-Index ETN, symbol JJA), just exactly the same way we would buy a stock through our brokerage account. What more could we ask?

Not so fast. I have been studying these new vehicles, and finding some pretty scary things about them. They are high risk because the ETF managers buy futures contracts to fund them. They have to roll the contracts over every 3 to 5 months, and can get hit hard by the differences in prices, depending on how many other people are trying to do the same thing. [Rolling a futures contract means selling the contract before it expires, and simultaneously buying a contract with a more distant expiry date. Like all other trades in an auction market, what you get for the contract you are selling, and what you pay for the new one you're buying are determined by supply and demand at the time you do it, and can materially affect your long term results. Why would you roll your contract before its expiry date? Because the two alternatives are riskier and usually worse, i.e., taking delivery of the actual commodity or taking whatever the market is willing to give you on that final date.]  As an investor, we have no idea how much premium or discount the market is pricing in compared to the net asset value of the underlying commodities. There is a limited supply of some of these products, meaning limited liquidity, and we have no idea how many traders or hedge funds are trading in them. Finally, if any of the commodity futures firms used by the ETF managers go bankrupt (due to failure of their customers to meet margin calls), ETF investors could lose all or part of their investment.

I might nibble a little on some of them, watching the charts carefully for opportunities to buy near the bottom of the trend channels, but I would want everyone to understand clearly that they are high risk speculations, unsuitable for anything other than money you can afford to lose.

I have just learned that Jim Rogers has collaborated with Merrill Lynch to create this kind of vehicle for his three commodity indexes mentioned above, as well as his entire commodity index (RICI). These are technically in the form of an exchange traded note (ETN), which matures in October, 2022, rather than an exchange traded fund (ETF). The effect is the same, you are investing in the basket of commodities contained in each index. Each of the four ETNs began trading on the American Stock Exchange in October, 2007. The agricultural ETN trades under the symbol RJA, the energy ETN under the symbol RJN, the metals ETN under the symbol RJZ, and the overall RICI ETN under the symbol RJI.

I am in the process of reading the prospectus for the agricultural ETN (www.elementsetn.com, click on prospectuses). It is 112 pages. Already I have noticed a couple of things which indicate to me that “investing with Rogers” could be somewhat safer than other ETFs. The managers of the ETNs are using eleven different commodity futures firms to fund the futures contracts. All 36 commodities in the RICI are included in RJI in the ratios originally established by Rogers (explained in the prospectus), and similarly for RJA, RJN and RJZ. I still believe many of the risks I have described above would be present, but I don’t want to draw final conclusions until I have read the RISK FACTORS section and other sections of the prospectus.

If you are interested in speculating in this type of investment, I would suggest that you read the prospectus, and print out one year, daily, charts on these four securities. I have reached the following conclusions to what is said above, as well as to some of the material from preceding letters.

Conclusions
I have a strong conviction that energy (primarily oil) should have a significant position in my investment portfolio, something near 22% if I believe that half the portfolio should be in commodities, and follow Rogers' allocation. That’s the easy part. The hard part is deciding in what form, or forms, the 22% should be in.

After I finish studying the Rogers ETNs, I may decide to take a position in his energy index ETN, symbol RJN. I do expect it will be safer than other ETFs, but I still expect it is a high-risk investment, and I cannot in good conscience recommend it at this time.

That leaves only one way to participate in oil…the common stocks of major oil companies. The problem there is I want only a small percent of my portfolio in stocks, as explained in Letter 19. Since that time I have substantially reduced my stocks and increased my cash (see Jay's Portfolio). I own only one oil stock at present. To be honest, I haven’t decided what I will do. Oil is near its all time high, and I don’t like to buy things making new highs. If we get a significant correction in oil, or in oil stocks, I will decide then whether to increase exposure to oil. In the interest of full disclosure, I do own some small oil royalties (inherited) and natural gas working interests purchased in the 1970s, which I have not previously included in my portfolio. In the last two years new gas wells have been drilled on the leases I participated in. Both are increasing in value (a blessing from God) and make a nice contribution to my energy allocation, so I have added them in.

I should mention in passing that I have one very small position in JJA (an agricultural ETF). If I do any more in ETFs, I will almost surely switch to the Rogers ETNs, but I am not recommending them at this time.

There is one thing I have a strong conviction about, and that is a 30% position in physical gold and silver. Silver has dropped $4 an ounce over the past couple of weeks. Its spot price is under $18 as this is written. If I didn’t have a full position (at least 20% of full portfolio) I would add here. You can use SLV to take a position quickly at near spot price, then later, when things are more stable, switch to coins or bars held in your possession. I recommend you read the essay titled ALL IN, by Theodore Butler and Israel Friedman, on www.silverseek.com. 

For future reference, here are the energy stocks I will consider in the future. Boone Pickens disclosed that CHK (Chesapeake Energy Corporation), XTO (XTO Energy Inc) and SU (Suncor Energy Inc) are in his portfolio currently. Maybury has ECA (Encana Corp), SLB (Schlumberger Limited) and SU (Suncor Energy Inc).  Maybury's associate, who works with him has RTP (Rio Tinto Plc) and VLO (Valero Energy). Rogers has previously revealed he owns RTP (Rio Tinto Plc) and SU (Suncor Energy Inc).

Supplementary article: How Safe Are Your ETFs?