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The Low-Risk Play on Unconventional Energy

Shale gas, oil sands, and many other unconventional sources of energy have revolutionized the industry. With the potential to eventually reverse the reliance of the U.S. on foreign sources of oil, unconventional energy sources have popped up both throughout the country and around the world. The companies that have tapped into those unconventional sources have seen spectacular rises in both price and popularity.

But every energy company comes with risk. That's why a new way to invest in alternative energy has so much promise -- but will it deliver? Let's take a closer look at this novel investment opportunity.

Going the ETF route
In the past several years, hundreds of new exchange-traded funds have appeared, covering any number of obscure, esoteric corners of the market. But with one new offering slated to start trading today, the ETF universe will gain from a targeted play on one of the hottest sectors of the stock market: unconventional energy.

The Market Vectors Unconventional Oil & Gas ETF will track an index of companies in the business of producing shale oil and gas, coalbed methane, and coal seam gas, along with "tight" sands, oil, and natural gas. With the apt ticker symbol FRAK, the ETF will carry a net expense ratio of 0.54%, which is fairly competitive with other focused-sector ETFs across the industry.

Given the number of small players involved in unconventional energy, this ETF may sound like a perfect opportunity to grab a mix of risky plays, giving you the maximum benefit of diversification. Unfortunately, although the ETF does include several dozen stocks, it falls short of its full potential by concentrating too heavily on some of the biggest companies in the space.

The usual concentration problem
To understand better what you're getting with the Market Vectors ETF, you need to turn to its underlying index. The so-called "pure play" index includes companies that "derive most of their revenues from unconventional oil and gas, or with properties that have the potential to do so" [emphasis added]. That additional caveat opens the door to well-established large-cap companies, which end up composing well over 80% of the assets of the fund. The top nine holdings alone make up over half the fund.

Granted, there's no denying that Chesapeake Energy (NYSE: CHK  ) and EOG Resources (NYSE: EOG  ) deserve a place in an unconventional energy ETF. Both companies have gone to great lengths to amass substantial positions in various shale gas areas, and both have been instrumental in spurring further development around the country.

It's just unfortunate when some of the most promising smaller companies in the business get so little play in the ETF. Low-cost leader Ultra Petroleum (NYSE: UPL  ) may have one of the most impressive cost structures in the natural gas industry, but the Market Vectors ETF only gives you a 0.9% position in the stock. Kodiak Oil & Gas (NYSE: KOG  ) seems like a natural growth play in the Bakken shale area, as it just added acreage in the area along with some pipeline facilities to boot. But it only gets a 0.6% allocation. And fellow Bakken company Northern Oil & Gas (AMEX: NOG  ) sports only 0.36% of the ETF's assets, yet it has managed to amass significant production without raising debt and as a non-operating company that's partnered up with drillers.

Is this what you want?
Despite its shortcomings, the Market Vectors ETF will very likely perform in line with energy prices overall and with the state of the unconventional energy industry in particular. With more than 70% of the ETF's holdings based in the U.S., any federal regulations governing hydraulic fracturing or other common unconventional techniques would have a big impact on all of its holdings.

So if you're looking for general exposure to unconventional energy, the Market Vectors ETF will get the job done adequately. However, if you really want to focus on the riskiest plays in the sector, you'll need to supplement the ETF with bigger positions in the small stocks that the ETF largely neglects.

If you like energy stocks, we've got one that could knock your socks off. Read about it right here in The Motley Fool's special free report on the energy industry and its best prospects. It's free, but only available for a limited time.

Fool contributor Dan Caplinger likes ETFs that do their job right. You can follow him on Twitter here. He doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of Ultra Petroleum. Motley Fool newsletter services have recommended buying shares of Ultra Petroleum and Chesapeake Energy. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy never saps your energy.

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Related Tickers

10/24/2016 4:00 PM
CHK $6.36 Down -0.32 -4.79%
Chesapeake Energy CAPS Rating: ***
EOG $93.62 Down -0.26 -0.28%
EOG Resources CAPS Rating: ****
KOG.DL $0.00 Down +0.00 +0.00%
Kodiak Oil and Gas CAPS Rating: *****
NOG $2.55 Up +0.10 +4.08%
Northern Oil and G… CAPS Rating: **
UPLMQ $6.93 Down -0.01 -0.07%
Ultra Petroleum CAPS Rating: **