Is investing in oil as risky as it looks?

Experts are warning that supply disruption could become a major theme in the sector if the Islamic State in Iraq and the Levant forces move to the Kurdistan region, where the majority of Iraq’s oil production is located. Investors with holdings in the semi-autonomous Kurdistan region are closely monitoring the situation to ascertain whether there have been any major disruptions.

This conflict has implications that go beyond just the Middle East. For example, it also poses a threat to the Indian stock market, which is gaining popularity among investors following a positive reaction to NarendraModi’s appointment as prime minister, returning 9 per cent since he won a landslide election victory in May.

India relies heavily on imported oil, so a higher oil price (driven up by the situation in Iraq) would act as a drag on the economy. And it could also pose fiscal problems as the government subsidises fuel consumption.

The Brent Crude index, which tracks the price of global oil, has been relatively steady, especially when compared with other commodities such as gold and silver, which were very volatile last year. But the index dipped in June, spurring large inflows into funds tracking it. ETF Securities reported a 71.8 per cent inflow into its Long Brent Crude Index ETF in June.

Despite these ongoing problems, the situation in Opec countries is having a positive impact for oil equity investors, which are generally more focused on non-Opec countries such as Columbia and North America, according to James Sutton, client portfolio manager at JP Morgan Asset Management.

Investors with shares in oil and gas companies have generally seen their values holding up in the second quarter of 2014. But among those who are looking for growth, oil giants such as BP (BP.), ExxonMobil (US: XOM) and Chevron (US: CVX) look likely to disappoint. “Not only have large oil stocks been posting poor growth forecasts, they have been failing to achieve them too,” says Mr Sutton. He believes investors looking for long-term growth would be much better off buying smaller exploration-based oil companies in the US, Columbia and Kurdistan. In the US, he likes Anadarko (US: APC), Continental Resources (US: CLR) and Suncor Energy (Can: SU), while in Columbia he owns Parex Resources (Can: PXT) and Gran Tierra (Can: GTE). But one of the biggest holdings in his portfolio (2.5 per cent) is DNO International (Nor: DNO), a Kurdistan-based oil producer which he claims has “surprised investors by constantly and aggressively growing over the last three years”.

Small-cap oil companies such as these are undervalued, and present a buying opportunity, according to AngelosDamaskos, manager of the Junior Oils Trust (GB00B01YQF73). In 2011, small-cap oil companies fell massively out of favour and valuations have remained low, with an average price to cash flow multiple of 3.5 times, down from eight times in 2011. Like many other fund managers, Mr Damaskos refuses to go anywhere near buying oil stocks based in the Middle East, due to the political risks.

Funds for oil exposure

If you like the idea of exposing a small part of your portfolio to oil, but you feel a dedicated fund is too risky, there are a number of broad investment trusts that have a relatively large weighting towards it.

We like Blackrock Emerging Markets Trust (BEEP) which has a 31.3 per cent of its portfolio invested in oil companies. It invests mainly in Russia, Turkey and Poland, with a small allocation to the Middle East. Earlier this year, it changed its investment policy and reduced its holdings from 45 to between 20 and 30, so its managers can adopt a more conviction-based approach, looking beyond large companies which dominate its benchmark in favour of the "best" ideas in their investment universe. The trust is currently trading on a 6.2 per cent discount to its underlying net asset value, making it look like a bargain.

BEEP's co-manager Sam Vecht is an experienced manager who also runs BlackRock Frontiers Investment Trust (BRFI), which invests in regions such as Nigeria, Kuwait and Pakistan, and has a 15.1 per cent allocation to oil stocks. However, its stellar performance has pushed its share price to a 1.87 per cent premium to NAV, making it look expensive.

If you’re looking for low-cost ways into oil, there are a number of exchange traded funds (ETFs) that track the Brent Crude oil price, but these can be highly volatile. If you want to track oil production companies, there’s iShares Oil & Gas Exploration & Production UCITS ETF (USD) (IOGP), which has a total expense ratio (TER) of 0.55 per cent. If you want heavy access to oil and the energy sector, a Russian ETF should also do the job. The Market Vectors Russia ETF (US: RSX) is the largest and most heavily traded Russia ETF, and has a heavy 40.2 per cent allocation toward the energy sector. iShares MSCI Russia Capped ETF (US: ERUS) also has a heavy 55.4 per cent weight. RSX has a 0.63 per cent expense ratio and ERUS has a 0.61 per cent expense ratio.

But the lowest cost option available is the Temple Bar Investment Trust (TMPL), which only has a 12.8 per cent of its portfolio in oil, but it has a super-cheap TER of 0.49 per cent. It's a UK-focused fund that has returned 9 per cent in the last year (to 7 July 2014), according to Morningstar, and a healthy 45 per cent over three years. As well as oil & gas, it also invests heavily in financials (14.8 per cent) and has a large portion of its portfolio in cash (14.5 per cent).

Funds to reduce oil exposure in your portfolio

From the recent political turbulence that could unnerve the market, to the long-term threat of environmental hazard, there are a number of reasons why you might decide that the risks associated with the commodity are simply too big for your portfolio. This may mean you want to scale back the amount of oil exposure in your Russian and emerging market funds, which tend to have relatively large exposures.

In the wake of the Ukraine crisis, a number of daring investors are taking punts on a Russian fund as the stock market has fallen dramatically. However, because Russia is such a big exporter of oil, Russian funds tend to be very heavy on oil stocks. This can lead to over-exposure, even for investors keen to get some in their portfolio. For example, Pictet Russia Index USD (LU0625741789) has a massive 58.1 per cent allocation to oil. The fund has lost 4.8 per cent over the last year (to 07/07/14)

A Russia fund that's much lighter on oil exposure is Neptune Russia & Greater Russia Fund (GB00B04H0T52). It has underperformed its benchmark index, MSCI Russia Large Cap, over one, three and five years but analysts say this is why it looks so attractive now. It's got 25 per cent of its portfolio in the energy sector, with a further 16.2 per cent in consumer staples and 13.6 per cent in telecommunications. The ongoing charges are 1.9 per cent, which is reasonable for an esoteric single region fund, and there is no performance fee. But don't be lulled into a sense of security by this fund's relatively low weighting to energy, as it is still one of the riskiest funds you could choose to put your money in.

If you want an emerging markets fund without energy exposure, you could be hunting around for ages as most of them have a generous allocation. But JP Morgan's Emerging Markets fund (GB00B1YX4S73) currently does not feature oil and gas stocks in its top 19 sectors. Its manager, Austin Forey, runs a fairly concentrated portfolio, typically consisting of 60-75 holdings. Trading within the portfolio is kept to a minimum and a number of holdings have been held for over a decade. To manage risk, the team aims for a diversified portfolio by analysing the level of correlation between companies in the fund. The fund has lost 6.4 per cent over one year, but over five years it has returned 46.8 per cent, compared to a 45.5 per cent sector average (IMA Emerging Markets Equity).

Funds with the highest oil and gas exposure

General funds with the highest oil and gas exposure