Finding The Right Oil ETF For A Crude Rally

by on May 19, 2010 | Updated November 6, 2012 | ETFs Mentioned:

As storm clouds continue to gather over the euro zone, the repercussions of a rise in uncertainty have been felt in nearly every corner of the global economy. All assets denominated in euro have fallen out of favor. Financial stocks with exposure to European debt have been sold off. Even South American emerging markets have been battered by a wave of risk aversion as investors seek out the security of safe havens [sign up for the ETFdb newsletter to get updates on launches and analysis].

Crude oil has also felt the weight of uncertainty in recent weeks, as front-month futures contracts have now declined in ten of the last 11 trading days, the longest losing streak since October 2003. After an early rally dissipated on Tuesday, crude settled below $70 per barrel. The United States Oil Fund (USO), which offers exposure to crude through a futures-based strategy, has now lost more than 16% over the last month and 10% over the last week (see USO’s returns).

There are several reasons for the recent plunge. As confidence in the euro has been shaken, the U.S. dollar has staged an impressive rally, driving down global commodity prices (a rising dollar makes commodities more expensive to foreign consumers). OPEC members have publicly expressed plans to maintain steep production cuts, but actual compliance with stated objectives has been abysmal. Despite rises in confidence and projected output, many factories are still operating at only a fraction of pre-recession levels. And with many consumers still carefully monitoring their expenses, retail demand for gasoline remains far more elastic than it has been historically.

ETFs For Playing The Crude Rally

With memories of $4 gas still fresh in their minds, many investors are wondering if oil’s recent dip has created an attractive entry point. While there are some who believe that $50 oil by the end of the summer is entirely reasonable, most investors are anticipating a rebound in crude oil prices in coming months. Demand from China continues to surge, as the world’s largest emerging market maintains an insatiable appetite for raw materials. The Energy Information Administration said in a recent report that it sees crude prices around $87 per barrel in the fourth quarter of 2011, with oil climbing to $84 before this year is over.

For investors looking to make a bet on rising oil prices, there are a number of ETF options. Below, we profile several different ways to play a rally in crude oil prices through ETFs (sign up for our free ETF newsletter for more investment ideas).

Futures-Based ETFs

Much of the growth in the ETF industry in recent years has been attributable to exchange-traded commodity products. While a handful of ETFs offer exposure to certain commodities (mostly precious metals) in physically-backed form, most utilize a futures-based strategy to track movements in commodity prices (see What Every Investor Should Know About Commodity ETF Investing). Just as there are many different types of oil, there are a handful of ETFs that invest in energy futures contracts:

  • United States Oil Fund (USO): This fund invests in near month futures contracts on light, sweet crude oil; currently, holdings consist of July 2010 contracts (see Five Reasons USO Is Due To Rally).
  • United States 12 Month Oil (USL): Similar to USO, this fund invests in futures contracts on light, sweet crude oil. But instead of focusing on near-month contracts, USL spreads exposure across the futures curve (see USL holdings).
  • United States Gasoline (UGA): This ETF invests in futures contracts on unleaded gasoline traded on the NYMEX (see UGA holdings).
  • PowerShares DB Energy (DBE): This product offers exposure to a number of energy commodities; the underlying index consists of futures contracts on light sweet crude oil, heating oil, Brent crude oil, RBOB gasoline, and natural gas (see DBE’s holdings).

In addition to these funds, there are several more ETF options for exposure to oil futures; see all ETFs and ETNs in the Oil & Gas ETFdb Category.

A word of warning on ETPs that rely on futures-based strategies: while they will generally exhibit a strong correlation with the market price of the underlying commodities, returns will also be impacted by the “roll yield” incurred or earned when expiring contracts are sold and longer-dated futures are purchased. Currently, the market for WTI crude is in contango; July futures are trading at a 10% premium to June contracts.

Energy Equities

Historically, many investors looking to make a bet on rising oil prices have done so through stocks of oil companies. Because profitability of “Big Oil” tends to rise along with spot prices, companies like Exxon, Chevron, and BP can deliver impressive performances when crude is on the rise (see Gulf Spill Contaminates Oil ETFs). In addition to broad-based sector ETFs such as the Energy Select Sector SPDR (XLE), there are now a handful of more targeted ETF options within the energy sector, including:

  • SPDR S&P Oil & Gas Exploration & Production ETF (XOP)
  • iShares Dow Jones U.S. Oil Equipment Index Fund (IEZ)
  • PowerShares Dynamic Oil & Gas Services (PXJ)

These are only a handful of the ETFs offering exposure to oil companies; see a complete list of the Energy Equities ETFdb Category.

Leveraged ETF Options

For risk-hungry investors looking to place a leveraged bet on oil, there are a handful of leveraged ETFs that offer a way to increase exposure (see our Leveraged ETF Center for more on the uses of these products).

  • ProShares Ultra DJ-UBS Crude Oil (UCO): This leveraged ETFs seeks daily returns equal to 20% of the Dow Jones-UBS Crude Oil Sub-Index, a benchmark consisting of crude oil futures. For those who think prices will continue their slide, there’s also a -200% version of this fund (SCO).
  • Direxion Daily Energy Bull 3x Shares (ERX): This ETF offers 3x leveraged exposure to the Russell 1000 Energy Index, a benchmark comprised of oil-related stocks. Direxion also offers a Bear counterpart to this ETF; ERY seeks to deliver daily returns equal to -300% of the same index.
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Disclosure: No positions at time of writing.