For this post, I interviewed Chris Konstantinos from RiverFront Investment Group to get his views on adding exposure to oil and using single country ETFs to do so. Chris is Director of International Portfolio Management at RiverFront.

Jay Jacobs: The rebound in commodities has been one of the biggest stories of 2016, particularly as commodity-related investments have struggled mightily since the end of the commodity super-cycle in 2011 and the oil selloff in 2014.

Earlier this year, you initiated positions in single country ETFs with high exposures to commodities like oil. Did you see any indicators that convinced you that oil was looking attractive?

Chris Konstantinos: Just to be clear, we don’t view ourselves as prognosticators of energy prices. It wasn’t necessarily that we had this revelation that we reached a bottom in oil. It actually had less to do with the energy input prices and more to do with the fact that we were noticing through our valuation work and modeling that the embedded oil prices in certain sectors were pricing in a margin of safety that made those stocks attractive. If the embedded price of oil in an asset class has been priced meaningfully below where the oil is actually trading, then that gives us a Warren Buffet-esque “margin of safety” that makes us more comfortable to invest. It doesn’t require being spot on in terms of getting the oil call exactly right. It just gives us a margin for error that, on a risk-reward basis, we believe is highly attractive.

JJ: So really it was a value play. If oil was trading at about $35, but you were seeing that oil-related equities were implicitly pricing oil at say, $25, then you felt this tipped the odds in your favor for that trade.

CK: Right. Our international and domestic equity teams collectively came to this view back in the fall of 2015, and the first place we looked to express this view was in the US. Our team, spearheaded by quantitative analysis by a few of my colleagues, did deep fundamental work that suggested that pound for pound US energy companies, first of which was oil field services and then later on MLPs (Master Limited Partnerships), were the more attractive areas at that time.

Then, in 2016, we thought that the margin of safety was strong enough in some of the international markets for us to start going back in there as well. I should also say that the 2016 trade had a lot to do with central bank policy in the international space. One of the things we recognized coming out of the G20 meeting in November 2015 was that the dollar had become less volatile and the Chinese yuan was stabilizing. That, in our opinion, was a big deal for some of the commodity-related currencies outside of the US.

I’ll use Norway as an example – At the time we started allocating to Norway this year, the Norwegian stock market (this is a market-cap weighted Thomson Reuters Datastream DS country index, in USD) was well over -20% lower in dollar terms than at the beginning of 2013, despite the fact that US and World stock markets were significantly higher than where they were in 2013. From a relative perspective, Norway was a massive underperformer and its currency, the Norwegian krona, was a massive underperformer.

RiverFront’s belief was that if we could get some stability in Chinese monetary policy, along with what we believed to be a bottom in oil, (and again, I say this with a grain of salt because predicting oil or predicting energy prices is very difficult to do) then we’ve reached some kind of messy bottom. It doesn’t mean we can’t go back to a two-handle on oil again in the next six months. But it does mean that three years from now, we think oil is going to be trading higher than where it is today, or at least in the range where efficient oil producers can make money.

Our view was that one of the best ways to play this bottom was to get exposure to the currencies of some countries, like Norway and Australia, which had a lot of potential to catch up and are often highly positively correlated to commodities.

JJ: Of all the oil-producing countries, why Norway?

CK: I have a couple of Norway-specific points to make. The first one is that of all the petro states in the world, geopolitically Norway is by far the most stable. It’s the richest. It’s the most politically stable. In an era of heightened geopolitics, that’s an attractive characteristic of that market.

The second point I’d like to make is that in a Europe where more than half of sovereign debt is at negative interest rates, the dividend yields on Norwegian stocks are highly attractive. If you think that the currency can stop going down because of increased stability in the emerging world and with the dollar, if you think that the dividend yields are highly attractive, if you think that it’s got the kind of correlation to energy that you’re looking for but without geopolitical risk, and on top of all of that, it’s trading cheap relative to its own history, then Norway looks like a very attractive place to invest.

JJ: Why did you decide to use a single country ETF to express an opinion on oil rather than buying individual companies? If you buy a Norway ETF, you’re not just getting exposure to the oil equities in Norway but also the financials, the consumer staples, etc.

CK: When you look at the Norwegian Stock Market, its correlation to oil is extraordinarily high, historically speaking. So even though you’re buying a diversified index, you’re buying an index that’s very likely to trade with oil. Even the banks are highly correlated to the price of oil because a lot of their deposits come from the oil or gas-producing industry, either directly or indirectly. That’s the return reason.

The risk reason is that your conviction levels to justify owning an individual equity have to be really, really high because you’re taking on so much idiosyncratic risk. Trying to express a macro bet by owning a specific security is fraught with peril.

Let’s use the example of a bellwether S&P 500 global exporter from a couple of years ago. Say you buy the stock because you wanted to play the global cycle. Well that’s great, except one quarter they end up admitting that a company they purchased turned out to be a fraud which required a multi-billion dollar write down of earnings, and the stock sold off. So maybe you got your global macro bet right, but picked the wrong instrument. The stock had company-specific risk that had nothing to do with your macro bet and that ultimately torpedoed your gains.

One of the reasons we love using ETFs so much is that ETFs give you broad, diversified, liquid exposure in an efficient manner that helps mitigate company-specific risk. In fact, it’s fair to say that in the international space, we use 100% ETFs for primarily this reason.

JJ: Within the international space, do you see most of the opportunity aligning with the recent developments in the commodities market or do you still see it being driven largely by central bank policies?

CK: I think it’s both because it’s hard to separate one from the other. We believe a lot of the rally in oil had to do with the weakness in the US dollar. The weakness in the US dollar had a lot to do with Federal Reserve policy and the fact that Federal Reserve has been very dovish – more dovish than many people expected in these past couple of months. This has, in turn, helped the international markets, and in particular, the emerging markets. The commodity markets also benefited because it reduced the risk of having a credit crisis in the commodity world.