This Oil Play Will Burn You

Anyone who thought the energy sector had gotten knocked out has had a rude awakening. After taking an 8 count, oil has bounced back in a major way, and investors want to know how to cash in. Although there are countless ways you can try to profit from rising energy prices, one increasingly popular method carries with it some substantial risks -- risks that aren't necessarily obvious.

The roller-coaster ride
If you drive a car, you know very well what happened with energy prices in 2008. Oil soared to nearly $150 per barrel during the summer, only to crash in a dramatic freefall to lows below $35. Along the way, the energy bust took most of the big oil stocks down with it:

Stock

Return, June 13, 2008 to March 12, 2009

Return, March 12, 2009 to June 12, 2009

ExxonMobil (NYSE: XOM  )

(22.8%)

10.5%

Chevron (NYSE: CVX  )

(34.6%)

15.7%

BP (NYSE: BP  )

(41.1%)

36.3%

Total (NYSE: TOT  )

(36.8%)

19.3%

Marathon Oil (NYSE: MRO  )

(53.1%)

38.7%

Source: Yahoo! Finance.

In addition, other commodities-related stocks, such as ag-sector fertilizer companies PotashCorp (NYSE: POT  ) and Agrium (NYSE: AGU  ) , also saw big declines.

But now crude has doubled from its lows. And as the table above also shows, as crude prices have come back -- along with the rest of the stock market -- many of those beaten-down energy stocks have recovered substantially, and have found their way back into the good graces of trend-following investors as well.

Where's my double?
You'll notice, though, that none of those oil stocks has doubled -- even though the price of crude has. It's exactly that disconnect that has sent many investors looking for more direct ways to profit from moves in the price of commodities like crude oil.

A number of exchange-traded funds have come out in recent years to give investors this kind of direct exposure to commodities prices. The United States Oil Fund is one such ETF; its price is connected to the behavior of oil prices.

As you'd expect, this oil ETF suffered some extreme losses last year. Between early July, when oil topped out above $145 per barrel, and its December lows, shares of the oil ETF lost nearly 72% of their value -- almost matching the downward move in the price of oil.

More recently, though, the oil ETF hasn't done what investors would have hoped. Those who bought shares back in December and have seen crude double probably expected to see the ETF double as well. But in reality, although the price has gone up, it's risen by less than 20% -- a slap in the face to those who expected the fund to pay off handsomely.

What's the problem?
The reason the oil ETF hasn't paid bigger profits has to do with the oil futures market. To track the price of oil, the ETF invests in futures contracts, typically ones that are set to expire in the near future. In order to stay invested, the fund has to roll its futures contracts over into the next month's contract when they expire every month.

Lately, the oil market has been in contango, which means that the prices of futures contracts get progressively more expensive the further out you go into the future. What that means for United States Oil Fund shareholders is that even as spot oil prices climb, profits have been eroded away by the transaction costs associated with maintaining the fund's futures positions. Even though shareholders made the right call, they didn't profit from it.

Buyer beware
None of this is news to anyone who looked closely at the fund's literature. But all too often, it's easier simply to assume you understand how an ETF or other investment works without looking at the details.

If you buy something without knowing exactly how it works or how it will likely respond to changing market conditions, then you're setting yourself up for disappointment. At best, you won't get what you expected -- and at worst, you could get severely burned.

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Fool contributor Dan Caplinger already went through his pyromaniac phase. He doesn't own shares of the companies mentioned. Total is a Motley Fool Income Investor recommendation. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy is too hot to handle.


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  • Report this Comment On June 16, 2009, at 12:08 PM, stockjock43 wrote:

    Author...answer this please....does the same hold true for the UNG fund? Thanks

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