How You Can Profit From the Next Oil Bust

For years, the bulls have run rampant in the oil patch. If you think their exuberance has finally reached the irrational stage, there's an exchange-traded fund that provides a quick and easy way to bet against energy.

The ProShares UltraShort Oil & Gas fund (AMEX: DUG  ) provides a simple way to make money if the energy sector stumbles. Using an ETF to get short exposure to energy has several advantages, including no margin calls or contract expirations to worry about. You also don't need exquisite timing on energy prices, as you can hold the ETF indefinitely.

Fund facts

  • Inception date: Jan. 30, 2007
  • Expense ratio: 0.95%
  • Net assets: $1.4 billion

About the fund
ProShares tracks the Dow Jones U.S. Oil & Gas Index, which measures the performance of the energy sector of the U.S. equity market. Unlike many index trackers, the fund seeks daily investment results that correspond to double the inverse (opposite) of the index's daily performance. So if the index falls 1%, the fund should go up by 2%.

Although the index includes more than 80 energy-related companies involved in oil drilling equipment and services, coal, and oil companies, it is dominated by major oil companies. ExxonMobil (NYSE: XOM  ) , Chevron (NYSE: CVX  ) , and ConocoPhillips (NYSE: COP  ) together make up close to half of the index.

All three of these oil majors have seen their share prices march higher over the past five years. That's largely responsible for the fund's atrocious performance; it has lost half its value since its inception slightly more than a year ago.

Risks
The drop in the ProShares ETF's share price shows you firsthand the risks involved. Selling stocks short is always a risky proposition. Moreover, oil prices are extremely volatile and move rapidly on rumors and speculation, as well as supply and demand factors. Yet those movements in oil prices often translate into unpredictable effects on shares of oil companies. For instance, although oil is at record highs, refiner Valero Energy (NYSE: VLO  ) has seen its shares drop 30% this year on narrowing spreads.

When you add to that ongoing uncertainty in both the Middle East and other oil-producing nations like Nigeria and Venezuela, and a seemingly ever-declining dollar, betting against energy seems like the ultimate contrarian's folly. However, in the past, high energy prices eventually led to reduced demand for oil, as businesses and consumers found alternatives or altered their habits. Politics could also prove problematic for oil stocks, as proposed taxes on producers and alternative-energy policies could have an adverse effect on the sector.

Does it belong in your portfolio?
With oil prices having doubled in the past 12 months, and Goldman Sachs (NYSE: GS  ) estimating that prices may keep heading skyward, it's clear that investors in this ETF have taken it on the chin so far. Yet when the bloom comes off oil prices, energy companies will likely experience significant stock price declines.

So if you want to go against popular wisdom and have patience, putting a small amount of money in this oil-bear ETF may pay off. But you should think of it as speculation, rather than a true investment. And if you're convinced energy will keep outperforming, an ETF like iShares DJ Energy Sector (NYSE: IYE  ) may be the better fund for you.

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Fool contributor Zoe Van Schyndel lives in Miami and enjoys the sunshine and variety of the Magic City. She owns shares of ProShares UltraShort Oil & Gas. The Motley Fool's disclosure policy owns three pairs of blue gingham shorts.


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