In today's challenging markets, many investors are turning to sector investing. The energy sector may be a good place to begin for two reasons.
First, energy is a necessity of modern life. Second, the energy sector has been beaten down over the past year. For example, the price of crude oil is down over 50% from its June 20, 2014 peak. A collapse of this magnitude is often considered a significant opportunity for investors. However, before you dive in, it would be prudent to understand the different types of energy investments and their associated risks. Last month we discussed the role of energy in society. In this article we'll look at investing in energy using ETFs and mutual funds.
Overview
When selecting an energy ETF or mutual fund, a good first step would be to choose an energy category. According to Morningstar, Inc., there are three categories for energy ETFs and two for mutual funds. Then, you could choose between an active or passive fund.
Energy Categories
Commodities Energy
Commodities Energy portfolios invest in oil (crude, heating, and gas), natural gas, coal, kerosene, diesel fuel, and propane. Investments can be made directly in physical assets or commodity-linked derivative instruments.
Equity Energy
Equity Energy portfolios invest primarily in equity securities of U.S. or non-U.S. companies who conduct business primarily in energy-related industries. This includes, but is not limited to companies in alternative energy, coal, exploration, oil and gas services, pipelines, natural gas services, and refineries.
Energy Limited Partnership
Energy Limited Partnership funds invest a significant amount of their portfolio in energy master limited partnerships. These include, but are not limited to, limited partnerships specializing in midstream operations in the energy industry (more on this in a moment).
The first category is the most unique in that it invests in the physical commodity or in commodity-linked derivatives. In the Equity Energy and Energy Limited Partnership categories, the target investments are similar, however, the tax treatment varies. Moreover, the target companies of the latter categories can be divided as follows:
- Upstream
- Midstream
- Downstream
Upstream companies are engaged in the exploration and production of energy resources. This includes companies that drill for oil, mine coal, and extract other energy resources. Midstream companies are those involved in the transportation or storage of the commodity. They don't actually own the commodity, but earn a fee on the amount they transport through their pipeline system or hold in storage. Downstream companies sell the product to the user. It's worth noting that the majority of Master Limited Partnerships operate in the energy sector and the vast majority of MLPs consist of midstream companies. For reasons that extend beyond the scope of this article, midstream companies have found the pass-through nature of the MLP structure especially appealing. Since each category differs, in terms of strategy and target investment, their risk profiles vary greatly.
