The Wrong Way to Play Energy Right Now

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.

Fool contributor Dan Caplinger has a lot of energy right now. He doesn't own shares of the companies mentioned in this article, having learned his lesson about these ETFs. Chevron is a Motley Fool Income Investor recommendation. The Fool owns shares of ExxonMobil. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy is clean-burning and never stops running.


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Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On February 27, 2011, at 5:37 PM, RRobertsmith wrote:

    UNG was a bad bitter pill to swallow this spring...I would much, much rather trade XOM, only silly non traders make glowing etf endorsements, such as this (above).

  • Report this Comment On March 01, 2011, at 12:28 PM, MikeInSA wrote:

    This would all be great if not for an inconvenient thing called history. Even a cursory glance at historical prices shows that oil companies have not kept pace with rises in the price of oil nearly as well as the ETFs.

    Looking at our last run up, the price of oil in early January 2007 was $56.31 a barrel and it peaked in July 2008 at 147.29 meaning $10,000 worth of crude bought in Jan 2007 would have been worth $26,157 at peak. Taking Exxon for example during that last oil price run up, in January 2007 Exxon stock sat at 74.10 per share. It peaked at 93.69 in December 2007 when oil was at $96 bbl. When oil peaked at $147 bbl, where was XOM? Down to $88.13 per share, that's where. Now look at US Oil. It sold at $48.24 per share in Jan 2007. When XOM peaked in December 2007, USO was at 75.76 and it kept going up to $113.66 in July 2008 when oil peaked. So while crude oil jumped 161% from Jan 2007-July 2008, USO increased 137%, but XOM increased a measly 19%. Did USO keep exact pace with the price of oil? No, but it was close. Exxon stock wasn't even on the same planet even with dividends added in. Even when XOM performed at its best and peaked in Dec 2007 it had only increased 26% compared to USO's 57% and crude oil's 70% for the same time period.

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