The New Mining Services ETF: Lessons from the Oil PatchThe world’s first mining services ETF is now a half-quarter old, and investors are peeling back the layers on this unique investment to see if it’s living up to its billing of providing a safer, less-volatile way to play the current mining boom.

So far it’s been a pretty good ride for the PureFunds ISE Mining Service ETF (ARCA:MSXX), created by New Jersey-based fund designer PureFunds. Since launching on November 29, 2012, the fund is up 16 percent.

It appears that the ETF’s stated function of offering investors broad exposure to the mining services sector — by holding companies that provide engineering services, equipment contracting and drilling expertise for the minerals industry — is paying off.

Gains to date have been driven by holdings like Australian engineering firm Monadelphous Group (ASX:MND), which is up 14.3 percent since the ETF listed, and according to PureFunds’ website is currently the fund’s largest holding, representing about 7.7 percent of assets.

The fund’s second-largest holding — crushing equipment and services provider Mineral Resources (ASX:MIN) — has fared even better, rising 23.2 percent since the November 29 listing. Mineral Resources now makes up about 6.7 percent of assets.

A better way to ride the mining boom?

The Mining Service ETF’s gains are particularly impressive given the fact that they occurred during a period when the wider S&P 500 (INDEXSP:.INX) gained just 4 percent, while the supposedly mining-geared TSX (TSX:OSPTX) managed just a 3.3-percent rise.

The fund has also performed well against ETFs that hold pure mining stocks, with its 16-percent gain standing above the 13.3-percent uptick in the Horizons BetaPro S&P/TSX Global Base Metals Bull Plus+ ETF (TSX:HMU) — which tracks a basket of major mining stocks — during the last 45 days. The iShares S&P/TSX Global Gold Index Fund (TSX:XGD) of mining stocks actually fell 5.5 percent in the same period.

The Mining Service ETF also outperformed individual mining stocks such as BHP Billiton (ASX:BHP,NYSE:BHP,LSE:BLT), Rio Tinto (LSE:RIO,NYSE:RIO,ASX:RIO) and Barrick Gold (TSX:ABX,NYSE:ABX), which moved 7.2 percent, 12.2 percent and -2 percent, respectively.

This outperforming of mining service stocks was partly driven by recent concerns over cost escalation in the mining industry. With estimated building costs for projects like Barrick’s Pascua-Lama having risen from under $5 billion to as much as $8.5 billion — according to Reuters — investors are concerned that miners may be draining their cash flows and capital reserves faster than expected.

Mining services companies are the flip side of that equation, and potentially standing to benefit from cost escalation as they are able to charge higher rates for their in-demand products and services. At the very least — the reasoning goes — services firms should be able to break even by passing along increased costs for input products to their client mining firms.

Service companies also enjoy the benefit of quicker cash flows than their mining company counterparts, and are often paid as least partially up front upon the award of work contracts. Miners on the other hand, generally wait years (or even decades in some cases) to realize cash flow from production following a construction decision.

Lessons from the oil patch

This shorter time to cash flow has often been cited as an investment thesis for the better-developed oil field services sector.

Indeed, during petro-booms, oil field services companies have often been the preferred way for traditional investors wary of the discovery and development risks posed by exploration and production companies to play the oil sector.

These increased investment flows have often seen the services sector outperform producing companies by a significant margin. During the oil price run of 2005 to 2008, the SPDR S&P Oil & Gas Equipment and Services (ARCA:XES) subindex outperformed the wider S&P by nearly 400 percent. The S&P 500 Integrated Oil & Gas Sub Industry Index (INDEXSP:SP500-10102010) of producers and developers also outperformed the headline S&P index, but by a notably lesser 250 percent.

Looking back through history, the pattern of oil services stocks beating producers is even more marked. During the oil boom of 1978 to 1980, the Oil & Gas Equipment and Services subindex out-performed the S&P by a towering 700 percent, while the Integrated Oil & Gas subindex beat the main index by just 100 percent.

If the same pattern holds true in the mining business, services stocks — and the new ETF tracking them — could well be a better bet than production companies as a way of playing bull runs in the commodities.

The flip side of exuberance

But the same history shows that the outperformance of services stocks during bullish times can quickly turn to underperformance when investor sentiment swings the other way.

Following the oil price crash in 2008, oil field services stocks in the S&P subindex lost 300 percent more in value than the wider S&P. Better-cushioned integrated oil and gas producers lost less ground, falling by 150 percent more than the S&P.

The quick turn from bullishness to bearishness makes sense given the business model of most services stocks. While these companies are quick to cash flow when signing contracts during the good times, they are equally quick to cashlessness during downturns when new work stops coming in.

Producers, by contrast, have some ability to weather the storm by continuing to extract and sell their product — albeit at lower prices. That gives investors some cause to go easier on the share prices of these companies.

Bigger jobs mean less volatility?

Of course, the analogy between the petroleum and mining industries only goes so far.

One major difference between the sectors is the financial scope of projects. Most oil field services firms are focused on drilling wells — a job that generally ranges from hundreds of thousands to hundreds of millions of dollars per unit.

A single project in the mining business can eclipse those figures by orders of magnitude. Rio Tinto’s planned expansion of its iron ore mining facilities in the Australian Pilbara region, for example, will ring in at an estimated $20 billion over the next five years, according to the company’s website.

Getting a piece of contracts like these can keep a services company busy, and profitable, for a long time — perhaps long enough to outlast some downturns in commodities prices or the wider market.

The Mining Service ETF’s top holding, Monadelphous Group, recently secured preferred contractor status for the Pilbara project. Holding services companies tapped into mega-projects like this may thus provide some insulation against the ups and downs that have bit services firms in the oil business.

Upside and stability

As with all ETFs, the question arises: wouldn’t investors who like the services sector do fine simply buying a stock like Monadelphous directly, thereby doing away with the 0.69-percent fee tagged to the Mining Service ETF?

Again, the oil sector provides some reason to believe that owning a basket of services stocks through an ETF may make more sense than single-company investing.

By diversifying holdings across an ETF, investors can gain exposure to not only a variety of businesses, but also a variety of stock sizes — from large to small cap. Monadelphous Group is a $2.25-billion company. But the Mining Service ETF’s rules permit it to invest in companies down to a $100-million capitalization, letting it buy small-cap firms like Energold Drilling (TSXV:EGD) at a mere $140-million capitalization.

This diversification may be a good thing. In 2012, small-cap oil field services companies performed notably better than their larger counterparts, with the S&P 600 SmallCap Oil & Gas Equipment & Services subindex up 7 percent while the MidCap subindex lost nearly 6 percent and the LargeCap subindex finished flat.

But small-cap stocks also come with greater volatility — often with their future hinged on one or two major contracts. If an award fails to materialize, or the company fails to execute, much of the stock’s value can be lost overnight.

Combining the upside of well-chosen small-cap services stocks with the stability of larger, better-diversified firms through an ETF could offer the best of both worlds.

 

Securities Disclosure: I, Dave Forest, hold no direct investment interest in any company mentioned in this article.

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