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US energy infrastructure ETFs prove popular with investors

Download the special report Commodities Outlook 2014

For many investors, ETFs are fast becoming an effective way to engage in tactical trading. And when it comes to investment tactics, commodities represent one of the most challenging arenas in which to participate. Last year, the Dow Jones-UBS Commodity Index was down nearly 9 per cent. This was reflected in outflows from Exchange Traded Commodities (ETCs). Figures reported last December by London-based ETF consultancy firm, ETFGI, showed that commodity ETPs suffered a record level of USD39.7bn in net outflows for the year.

Already, though, things appear to be picking up. The DJUBS CI is now up over 6 per cent YTD and economic growth in OECD countries is helping commodities slowly move out of a three-year down cycle.
 
“If you look over the last 10 years, including the underperformance of the last three years, commodities as an asset class have actually outperformed developed market equities on a risk-adjusted level,” states Nicholas Brooks, Head of Research and Investment Strategy at ETF Securities. 
 
“The volatility of the broad commodity complex is slightly less than the S&P 500 index so on an absolute and risk-adjusted basis commodities have been one of the best performing asset classes.”
 
Much of the reason for recent poor performance, according to Brooks, has been the slowdown in Chinese economic growth from 10 to 12 per cent previously to 7 or 8 per cent more recently.
 
“The other factor was a supply response to the higher prices over a number of years. We saw an increase in supply across a number of key commodities but we think that outperformance cycle is over.
 
“That’s why we are slightly more bullish on commodities in 2014. We don’t expect to see performance that will shoot the lights out but we forecast solid high single digit returns as long as we see continued economic growth in developed markets,” says Brooks.
 
In terms of outflows last year, Brooks notes that gold ETPs were the main casualty but with respect to industrial metals a spike of interest was noted in long copper ETPs (ETFS ticker: COPA) towards the end of 2013. The largest inflows, however, were in the ETFS long coffee product (COFF), which tracks the Arabica coffee price.
 
“Arabica prices fell to seven-year lows last year and that attracted investors. Towards the end of 2013 we saw a large spike in the coffee price and that has continued into 2014. We’re starting to see investors taking some profits on that trade but certainly last year we saw significant inflows into our COFF product,” confirms Brooks.
 
Another trade that worked particularly well for investors was taking a long position in Henry Hub natural gas. Prices towards the end of the year climbed to USD4.41/MMBtu and have continued to rise in 2014 – reaching USD5.551/MMBtu on 24 February – as the brutal winter in America depletes gas supply inventories.   
 
“We are now starting to see tentative inflows into our short natural gas product, SNGA right now,” adds Brooks. “We think the natural gas price rose too high on the back of the cold weather in the US. We’ve had the short position on now for a while. The price has fallen to USD4.90/MMBtu but we think it can go down a lot further as we move into spring.”
 
The rotation out of precious metals such as gold and silver into more industrial-driven metals such as platinum and palladium indicates that investors are starting to gear up their investments to tap into the economic recovery taking place in the west.
 
MJ Lytle is chief development officer at Source. Lytle observes that whilst gold sustained substantial outflows in 2013, the fact that the gold price has stabilized in 2014 (it has risen from USD1,195 in December to USD1,334 at the timing of writing) shows that there is still value in gold.
 
“In Q3 we saw meaningful buying of gold for jewelry consumption in India. When the gold price dropped people bought more of it during the wedding season than they would otherwise have bought. China has also been a meaningful buyer of gold and this has emboldened investors to a degree. There remains, however, a big question mark over where the gold price will go. It’s still range-bound. Investors have lost their conviction that we will see large, sustained moves in the price of gold.
 
“We’ve seen a change in investors’ gold holdings from 4 per cent to around 2 per cent,” says Lytle.
 
One area of consensus among ETF providers is that crude oil is proving to be a difficult commodity to call. “I don’t see conviction in the oil price. I think the net consensus is slightly higher but I don’t see anyone calling for big price movements,” says Lytle. The spot price for WTI crude oil has been largely range-bound at around USD100/bbl since last year. Prices spiked at USD110/bbl at the end of August 2013 but have since mean-reverted. The same is true of Brent crude oil, currently trading at USD110.64/bbl. 
 
“We don’t see any major directional change in crude oil in 2014. There’s nothing we can see that will support a breakout. However, one area that is potentially profitable is the closing of the gap between Brent and WTI. With WTI currently trading above USD100 (USD102.82/bbl at the time of writing) the trade would be to long WTI and short Brent,” suggests Brooks.
 
The energy revolution taking place in the US is obviously an attractive proposition for investors. As already mentioned, natural gas has been a strong performer of late. But commodities are inherently complex. There is no straight-line relationship between the US energy boom and buying ETCs to gain exposure to commodity spot prices. Unless investors are exceptional, trading ETCs tactically to anticipate changes in spot price and volatility is nigh-on impossible.
   
One alternative to play the energy story is to invest in ETFs that provide exposure to commodity producers rather than the physical commodities. This is something that New York-based firm Global X Funds provides in its range of 11 commodity producer ETFs.
 
“Miners are perceived as a leveraged play on commodities. Generally if a commodity goes up the mining company goes up more, and vice versa. You saw that earlier this year with the gold price increasing in January while the stock price of gold miners increased significantly more. This was equally true last year when gold producers fell further than gold metal prices,” comments Bruno del Ama, CEO of Global X Funds.
 
Source’s Lytle says that investors are starting to show interest in the firm’s US energy infrastructure ETP (MLPS LN), an equity ETF that tracks the Morningstar MLP Composite Index TR. The constituents of this index are Master Limited Partnerships (MLPs), publicly traded partnerships engaged in the production, processing or transportation of energy or natural resources in the US.
 
“Using commodity prices simply as a way to harness a story [in this case the US energy boom] can often bring the wrong level of correlation. With something like an MLP, which is a company with consistent cash flows, then as long as people are investing in energy infrastructure on the premise that the energy revolution will continue, it will make money and draw off significant cashflows. This is a more direct correlation,” says Lytle.
 
Indeed, investing in the US energy infrastructure story is a trend that del Ama is also observing. The firm, like Source, offers an MLP and Junior MLP ETF, which invest in US energy infrastructure companies.   
 
“The amount of natural gas and shale gas exploration that’s taking place in the US is incredible. How, though, do you participate in that revolution without getting burned? Clearly, investing in spot or futures-based natural gas prices is risky. It’s going to be a very volatile trade for a while yet.
 
“In our opinion, a better option is to invest in the infrastructure being built around it, primarily pipeline to storage of natural gas. That type of investment is not driven much by the price of the commodity at all. It’s very much a growth business model and we think that’s a compelling market,” says del Ama.
 
Aside from offering investors exposure to commodity producers, Global X Funds specializes in highly niche commodities including metals such as lithium and uranium.  
 
“If investors want to make a call as to what the best producers might be within a specific sector like uranium, for example, our products allow investors and managers to make those tactical calls,” says del Ama, who believes that uranium, as a long-term supply/demand story, offers compelling investment opportunities to investors right now.
 
 “We are not massively constructive on industrial metals. The exception to that is uranium. The price displacement that took place following Fukushima went a little too overboard.
 
“It is clear that we are running at a deficit where the supply of new uranium being extracted is less than demand. We believe it is a question of when (not if) that price adjustment happens. Even though the industry dynamics are long term the price adjustments have historically been very quick. We are now starting to see uranium prices move upwards and we think it’s a very good time for investors to gain exposure,” explains del Ama. 
 
Year-to-date the fund has attracted USD30mn in net inflows; a decent level considering the fund is less than USD200mn in AuM. The supply constraint is due to various mining projects being put on hold, even though demand remains supportive with China continuing to build nuclear reactors.
 
It’s an interesting area of the commodity space, and a useful diversifier for investors who want to avoid both direct exposure to spot prices and to more ubiquitous industrial metals such as steel and aluminium.
 
One metal that Brooks says ETF Securities still favours is copper, citing an overestimation by analysts on the amount of supply coming into production in 2014.
 
“Analysts have extrapolated supply figures based on historical data but we think there could be some supply issues in 2014. We also think demand will remain strong both in China and the US. Copper inventories in Shanghai Futures Exchange (SHFE), London Metal Exchange and COMEX have been declining steadily which suggests that there is more demand than supply in the market.”
 
Although still not high on investors’ minds, there are interesting ways to gain exposure to commodities via ETFs. US energy infrastructure could well be a story for investors to pay close attention to going forward.

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Download the special report Commodities Outlook 2014


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