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The Definitive Oil ETF Guide: List of Oil ETFs and More

by Andy H on October 22, 2009 | ETFs Mentioned: DBO • DUG • IEO • IEZ • OIH • OIL • PXJ • USO • XES • XOP

Direct investment in crude oil products used to be limited to major financial institutions and oil companies themselves, but the development of the ETF industry in the U.S. has democratized the investment process in many ways, including making investments in various oil products accessible to average investors. There are a number of exchange-traded products that offer exposure to prices of various types of oil utilizing an array of investment strategies. And while gaining access to the prices of “black gold” is currently a relatively simple process, an increasingly cloudy regulatory environment threatens to make commodity investing via ETFs a thing of the past. Whether you’re looking to bet on short-term movements in oil prices or hedge against skyrocketing prices, ETFs offer an efficient, cheap, and easy way to gain exposure to commodity prices. But there’s a lot of information to digest for any investor looking to do so. Here’s a guide to some of the major issues to consider.

How Oil ETFs Work

At a high level, oil ETFs function just like any other exchange-traded product: they track an underlying index. But unlike traditional equity ETFs that hold a basket of securities comprising the underlying indexes, most oil ETFs achieve exposure in a very different manner. Because physically buying and holding most oil and gas products is prohibitively expensive (and in some cases, like natural gas, nearly logistically impossible), oil ETFs instead generally invest in near-term futures contracts on the underlying commodity to gain exposure to prices. While this strategy may track spot prices fairly closely in certain environments, it may be way off in others. If oil prices are in contango (longer term oil contracts are priced higher than near term ones), funds implementing this strategy will be continually rolling forward into more expensive contracts (see a more thorough discussion of this concept here). Other oil ETFs are structures as exchange-traded notes (ETNs), meaning that they actually own either the physical commodities or futures contracts, but are rather senior unsecured debt instruments issued by a financial institution that agrees to pay investors the return on a linked underlying index. The ETN structure reduces tracking error, but introduces investors to counterparty risk.

Oil ETF Price Movers

In the short term, predicting the factors likely to move the prices of oil ETFs is a daunting task. Given the presence of speculators in oil markets, as well as the impact of market news, short term prices can sometimes experience significant volatility. Over the long term, however, factors that impact oil prices are more clear, and include:

OPEC Production Levels: The underlying investments of the ETFs in this ETFdb Category will be exposed to the decisions of this cartel on oil prices and production levels. If concerns over weak demand arise, OPEC may decide to cut production. If however oil-producing nations are looking to increase revenues, increases in supply could lead to lower prices.
Alternative Energy Production: Demand for crude oil and natural gas will depend significantly on the development of alternative energy industries in coming decades. If solar energy and wind energy become viable sources of clean, renewable energy, demand for crude oil could diminish. If however, these industries continue to encounter obstacles on the road to sustainability, prices may continue to be propped up by dependence on oil.
Geopolitical Tensions: With much of the world’s proven oil reserves located in the Persian Gulf, the level of world output depends in large part on the stability of an occasionally unstable region. In the event of disruptions in crude oil production, the operations of companies in the energy sector may be impaired.
Natural Disasters: Generally unpredictable in nature, natural disasters, particularly hurricanes, can have a major impact on prices of oil and gas. Devastating storms usually result in significant output declines, months of recovery time, and extended reliance on alternative sources of energy.
New Discoveries: In recent years, we have seen major discoveries of crude oil off the coast of Brazil and huge natural gas reserves near Louisiana. To the extent that major discoveries are made going forward, prices may decline in response to increased global supplies.

Regulatory Environment

As oil ETFs have grown in size, some regulatory authorities have become concerned that the size of these funds is facilitating speculative behavior and contributing to overall market volatility. Most of the investigation and review on this subject has focused on natural gas futures contracts owned by UNG, but it is likely that any regulations would have an impact on all exchange-traded commodity products that utilize futures contracts to track prices. While the ultimate outcome remains to be seen, the most likely scenario is the implementation of position limits that prohibit a single fund from owning more than a predetermined number of contracts. Depending on the threshold determined, this could prevent commodity funds from expanding further, and may even force some to reduce their positions.

Popular Oil ETFs

Several of the most popular exchange-traded products offering exposure to prices of various oil and gas commodities are listed below. For a complete list, see our Oil & Gas ETFdb Category Page.

Ticker	ETF	Underlying Commodity
UNG	United States Natural Gas Fund	Natural Gas
USO	United States Oil Fund	West Texas Intermediate Crude Oil
UGA	United States Gasoline Fund	Gasoline
DBO	PowerShares DB Oil Fund	West Texas Intermediate Crude Oil
UHN	United States Heating Oil Fund	Heating Oil

Inverse and Leveraged Options

As is the case with most commodities, there are a variety of options for investors looking to gain leveraged or inverse exposure to oil prices through ETFs, including:

PowerShares DB Crude Oil Short (DDP)
PowerShares DB Crude Oil Double Long (DXO): Scheduled to liquidate in September 2009
PowerShares DB Crude Oil Double Short (DTO)
ProShares Ultra Crude Oil (UCO): Offers 200% leveraged daily exposure
ProShares UltraShort Crude Oil (SCO): Offers -200% leveraged daily exposure

Indirect ETF Investment Options

There are some drawbacks to investing “directly” in oil through the ETFs mentioned above. Since these ETFs primarily use futures contracts, they don’t always track spot prices closely (in certain environments, there may be significant discrepancies between the return on a basket of futures contracts and the spot price for the underlying asset). Moreover, in certain environments, commodity prices can exhibit extreme volatility (such as the run-up in oil prices above $150 per barrel in 2008 and subsequent decline below $50), making them inappropriate for some investors. For those looking to benefit from increases in oil prices without investing in commodities, there are a variety of energy ETFs that hold stocks of companies engaged in the production and distribution of oil. Broad-based energy funds generally have significant allocations to oil companies (such as Exxon Mobil, Chevron, and ConocoPhillips), as well as providers of drilling and other services to the energy industry (such as Schlumberger).

SPDR Energy Select Sector Fund (XLE)
Vanguard Energy ETF (VDE)
iShares Dow Jones U.S. Energy Index Fund (IYE)

There are also a number of global energy ETFs that include exposure to companies like BP PLC and Royal Dutch Shell PLC. Since both domestic and international oil companies typically generate the majority of their revenue and earnings outside of their home markets, global equity ETFs generally have strong correlations to domestic funds. Global energy ETFs include:

iShares S&P Global Energy Index (IYE)
WisdomTree International Energy ETF (DKA)

Beyond broad-based energy equities ETFs, there are a number of funds that target more specific corners of the industry. ETFs offering exposure to various sub-sectors of the energy industry include:

Oil Services HOLRDS (OIH): Invests in companies that provide various drilling and platform and pipeline construction companies such as Halliburton and Transocean.
iShares Dow Jones U.S. Oil Equipment & Services Index Fund (IEZ): Based on an index that tracks the performance of companies that are suppliers of equipment and services to oil fields and offshore platforms, such as drilling, exploration, and engineering.
iShares Dow Jones U.S. Oil & Gas Exploration & Production Index Fund (IEO): Based on an index that tracks the performance of companies engaged in the exploration for and extraction, production, refining, and supply of oil and gas products.

All of these ETFs generally have a strong correlation with oil prices. The correlations of these energy equities ETFs with OIL over the last two years have been strong, but far from perfect: