Junior Oils Trust research update

Despite efforts to diversify our energy supply, the world remains hooked on one key resource: oil. Continued economic growth in China and other emerging markets is expected to underpin demand, and although greater fuel efficiency and new sources of energy will have an impact, its status as the world's most important commodity is unlikely to change in the near term.

During previous bursts of global economic activity such as the industrial revolution and the post-World War II reconstruction, supply readily met demand for oil. The future could be different as oil is becoming more difficult and costly to extract. It means smaller companies owning accessible reserves could be increasingly highly prized by investors, and by the oil majors looking to increase their production.

Despite this, shares in many small oil companies have languished in the past couple of years, especially those not yet at production stage. In an environment of caution investors have seemingly shunned this area, so it could be due a return to form. Angelos Damaskos, manager of the Junior Oils Trust believes several factors could help spur a rally; further quantitative easing in the US, Chinese infrastructure spending, and continued instability in North Africa and the Middle East.

He invests in under-researched smaller companies with proven reserves and with strong production, exploration or development programmes. He also looks for takeover candidates by oil majors seeking to replenish reserves. Indeed a number of portfolio holdings were taken over by larger firms in the past year including Cove Energy, Encore Oil and Nautical Petroleum. This was positive for the fund as the acquiring firms paid a much higher price than the prevailing share price.

This is an exceptionally high risk sector-specific fund, investing in a concentrated portfolio of volatile smaller companies. It can also invest in higher risk emerging markets. This fund is aimed at sophisticated investors, and we suggest only a very small part of a portfolio should be allocated to it.

To avoid compounding risk, Angelos Damaskos avoids nations he views as politically unstable and where oil company assets could be seized. The areas represented in the fund therefore include the North Sea, Australia, Canada as well as certain parts of Asia and Latin America. The current portfolio includes Australian oil explorer Cooper Energy, Caza Oil & Gas, which is drilling across Texas, Louisiana and New Mexico, Parex Resources, which is exploring in Columbia and Xcite Energy, a North Sea production company.

Given the specialist nature of the fund, it has been tricky to discern whether Angelos Damaskos has added value for investors. However, using our own specially constructed global index of smaller oil stocks we believe that he has done so overall, with a strong period of relative outperformance in 2007 and 2008. Since launch in 2004 the fund has risen by 78% versus 86% for the specialist sector, though it has displayed a far higher level of volatility against this and the recent performance of smaller oil stocks has led to disappointing performance over the past couple of years.

Past performance is not a guide to future returns. Source: Lipper 08/10/2004 to 01/03/2013

For adventurous, long term investors wishing to access this niche area, and for those who believe the underperformance of smaller oil companies is likely to turn around, this fund may appeal. It remains on our Wealth 150 list of favourite funds across the major sectors.