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Are you ready for $4 gasoline? With the conflict in Libya and across the Middle East, you need to get ready -- and while the right investments could help you make money from rising energy costs, the wrong ones could leave you wondering what went wrong.
Oil prices are back at $100 per barrel, bringing back memories of the commodities boom that pushed oil almost to the $150 mark back in 2008. Many analysts believe the move up for oil may just be getting started. Yet if you want to profit from these big price moves -- and the potentially bigger ones that the future may bring -- you need to pick the best investments for the job. Unfortunately, some investment vehicles that seem like they should be ideal for the task have disappointed investors who didn't understand their peculiar quirks.
Energy ETFs and you
When exchange-traded funds first came out, they focused entirely on stocks. Even once sector ETFs became available, they still concentrated on the stocks within a particular industry.
That works perfectly fine for stock investors, and even as interest in commodities like oil grew, you could always buy ETFs that owned energy stocks. As long as the stocks traded roughly in line with oil prices, you could expect your energy stock ETF to go up when oil prices went up. However, as the BP (NYSE: BP ) crisis reminded investors recently, sometimes company-specific news trumps the impact of commodity prices on a stock.
To avoid stock-related risk, investors wanted a direct way to invest in energy commodities. In 2006, the United States Oil Fund (NYSE: USO ) gave investors a way to track the price of oil itself, rather than stocks. Subsequent years brought similar ETFs, including the United States Natural Gas Fund (NYSE: UNG ) and the United States Gasoline Fund (NYSE: UGA ) .
As you'd expect, the oil and gasoline related funds have seen big moves up in recent days as oil prices have skyrocketed. But a recent announcement from the natural gas ETF highlights a problem these vehicles have for longer-term investors.
Doing backward splits
Last week, the U.S. Natural Gas Fund announced that it would do a 1-for-2 reverse split of its shares, effective March 9. The move is necessary because shares of the ETF have fallen to just over $5, well below their initial trading price around $50 back in 2007.
It's true that natural gas hasn't performed terribly well in recent years. But if you're wondering whether gas prices have fallen 90%, the answer is no. The disparity comes from the fact that these ETFs use short-term futures contracts, which they roll over every month to the next contract. Because current-month futures in oil and gas tend to have lower prices than next-month futures -- a condition called contango -- the ETF slowly but steadily loses value over time.
The effect is easier to see with the U.S. Oil Fund. When shares came out, their initial $70 price was close to what a barrel of oil cost. Yet by mid-2008, shares topped out at around $120, well below the $147 high for crude. And now, with oil prices back near triple-digit levels, the ETF is stuck below $40 per share.
Stick with stocks
The experience of energy commodity ETFs has shown investors that it's crucial to understand the mechanics of the investment you're buying, or else you might be disappointed with the results you get. Over the years, major oil companies ExxonMobil (NYSE: XOM ) , Chevron (NYSE: CVX ) , and ConocoPhillips (NYSE: COP ) have not only risen along with the price of oil but have also paid substantial, regular dividends to investors, producing attractive total returns. Even BP's major catastrophe has merely returned it to 2004-05 levels.
If you're a short-term trader looking to try to capitalize on price spikes and dips from news in the Middle East, then ETFs like U.S. Oil should get the job done. But if you think the trend toward higher prices will take months or years to play out fully, don't go with these ETFs. Stick with smart stocks, and your returns will be far greater.
With markets getting turbulent, make sure your investment strategy will work for you. Take a look at 13 Steps to Investing Foolishly and make sure your portfolio will get the job done.