Oil ETF: Will Increasing Consumption Lift These Funds?

Getting a positive return on your investments is getting to be more difficult. Markets tend to be volatile, interest rates are forever being reduced, and inflation is going up seemingly non-stop. The value of everyone's money is in a downward spiral. In these uncertain times, some commodities are seeing historic prices. Under these conditions, the energy sector, particularly oil, is providing one of the safer bets for a persistent rise.

The major issue facing investors wishing to invest in the energy sector is deciding how to get in. Buying options tends to be risky and if a single company is to be selected, then which one. Fortunately, there is a minimal risk method of getting in. An index fund that is traded on a daily basis known as the exchange traded fund, or ETF, is a good way of moving in. These funds offer the investor diversification, along with the ease of trading like a normal stock.

With an ETF, the investor does not buy shares of a single company, but would own shares in a basket of companies in a specific industry. Take the oil industry for an example. An investor buying an oil ETF owns shares of multiple companies in the oil industry. That way when oil prices rise, the ETF value rises along with it. One example of an oil ETF is the Oil Services Holders (OIH) This fund is made up of companies dealing in the oil service industry and is made up of numerous companies. If one is seeking short-term investments in oil prices or a hedge against the ever increasing prices, oil ETFs provide a cheap and easy way to get into the oil commodities. There is just a single transaction – one price and immediate exposure to the oil industry. Also, ETFs benefit from continuous pricing, as opposed to end of the day pricing, can be sold short like stock, or bought on a margin. They generally have lower overall cost, are easy to trade, and have a small impact on the tax bill.

The reason oil ETFs are doing so well is because the price of oil is at a relative high. The price is increasing because the Peak Oil model is gaining grip. This theory states that the Earth's oil output is nearing its maximum. Even the US Secretary of Energy has acknowledged that “Peak Oil is now accepted as inevitable and the debate only becomes as to when.” Coming from an insider, this is a big statement. It is just common sense that oil prices will be precarious and subject to weather and natural disasters and disruptions. Also, new discoveries will no doubt lag behind consumption. The global oil industry will draw a minimum of three barrel equivalents of oil before discovering one new barrel. This translates to oil becoming more and more valuable and oil service companies with the technological knowledge and skills to create technological systems for mining hydrocarbons will also increase in value. Additionally, due the major price swings, crude has touched a peak of $145 and a bottom of $35 in the recent past; this offers an opportunity to make big profits in a very short amount of time.

Some of the more popular oil ETFs include the United States Natural Gas Fund (UNG) — dealing in natural gas, United States Oil Fund (USO) — dealing in West Texas Intermediate Crude Oil, United States Gasoline Fund (UGA) — dealing in gasoline, Power Shares DB Oil Fund (DBO) — dealing in West Texas Intermediate Crude Oil and United States Heating Oil Fund (UHN) — dealing in heating oil.

There are also some drawbacks to investing in oil through an ETF that should be kept in mind. The above mentioned ETFs use futures contracts and do not pay particular attention to spot prices. In some cases, there are major discrepancies in returns in the basket of futures contracts and spot prices for a given asset. In some cases there is extreme instability — like oil prices above $150 in 2008 followed by a low of $50. While this can mean making a lot of money in a short time, it could also translate into losing a lot of money in a short time, if one is not careful.

To help stabilize the oil investments, there are several strategies that can be employed. An oil ETF can be used to hedge against industry and foreign investments. If one is long on a lot of oil stocks, sell the oil ETF to hedge the downside. If there are investments in a country with oil being a major source of income, this can be used as an opportunity to sell oil ETFs to give downside a protection. Also, it is possible to buy inverse oil ETFs, which track oil price or the oil index in the reverse direction. These types of ETFs are great for investors who prefer selling short, but typically can't because of margin or other restrictions.