The Long and Short of Oil ETFs

Oil was both praised and pilloried last year, as the price of a barrel of oil reached heights never before seen and then steadily declined to shockingly low levels. Last year, the now-infamous Goldman Sachs (NYSE:GS) prediction for oil to hit $200 per barrel seemed entirely possible. But now, with supertankers serving as floating oil-storage facilities and oil inventories at more than adequate levels, there seems no end to the slippery black liquid.

Price volatility has made the energy sector something for ETF investors to watch. There are currently more than a dozen exchange-traded funds that have an oil focus, with both long and short funds to choose from.

Fund specifics
Typically, one can quickly narrow down ETF options to just a couple of funds. But oil funds offer many alternatives, including ones that track oil prices directly rather than just through stocks. Included on my short list are the ProShares Ultra DJ-AIG Crude Oil ETF (UCO), PowerShares DB Crude Oil Double Short ETN (DTO), and United States Oil Fund (USO).

These funds each use slightly different structures. The ProShares fund is a commodity pool designed to move up or down at twice the rate of its benchmark index every day. The PowerShares fund is an exchange traded note (ETN) whose value similarly doubles the return of its index, but in the opposite direction. United States Oil isn't designed for leveraged bets on crude prices, but it also has an unusual portfolio -- it can include listed crude oil futures contracts and other oil-related futures, forwards, and swap contracts.

Sources: Morningstar and fund companies.

Fund prospects and risks
Right now, there's too much oil on the world markets and too little demand. This might seem a positive thing for oil consumers, but the good times aren't likely to last forever.

At the same time, oil-price volatility shows no sign of slowing down. Demand from parts of the world that grow even as developed markets stagnate -- China being a good example -- should eventually sop up excess supply and bring oil production and demand back into balance.

In the short term, oil prices can swing based on rumors and speculation. But over longer periods, supply and demand have a much larger impact. Recent high energy prices have sent consumers and businesses scrambling to find alternatives. Now that oil is priced at lower levels, the trend away from this energy source has begun to reverse, and that new tendency will help to support or even increase the price level. In addition, OPEC has pledged deep cuts in oil production, which, if the organization follows through, will also help support prices.

Keep in mind, too, that these funds may not be as tax-efficient as some other ETFs. They warn you to consult your tax advisor about the federal income tax consequences of an investment -- that's an indication of the complexity of some of these funds, and it may be enough to put you off.

Portfolio fit?
The first choice you need to make is whether you want to track oil prices directly or through stocks. An energy-sector ETF such as the Energy SPDR (AMEX:XLE) include well-known names ExxonMobil (NYSE:XOM), Chevron (NYSE:CVX), and ConocoPhillips (NYSE:COP) in their portfolios. But such funds typically aren't pure oil plays: They also include natural-gas-focused companies such as Chesapeake Energy (NYSE:CHK) and EOG Resources (NYSE:EOG).

For those who want a fund directly connected to oil prices, these three funds each have good points, and they all give you slightly different ways to invest. Just be sure you understand exactly how each fund works before you make a final choice -- as well as the risk level involved with commodities investing.

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