Oil ETFs

Oil Exchange Traded Funds

The world needs oil. It is how we get to work, go home, and maintain our way of life. Oil serves our transportation needs, yet it also serves as the standard-bearer for all energy prices. As any economics 101 student learns, the price of oil affects the prices of electricity, natural gas, and other energy sources related to this precious and finite resource.

The constant need for oil is only one of the reasons the resource is a fantastic investment. The price is volatile and can easily fluctuate based on global events, but one thing has remained constant over the past half decade: The price of oil has risen and should continue to rise in the foreseeable future.
The Supply of Oil

As with everything else in the world, the supply of oil is one of the main factors in its price. There are many technological and political influences that affect the supply, but there is also a natural reason for a limited supply of oil.

Years ago, we assumed that oil would last forever. Geysers of the valuable black liquid were spewing a seemingly limitless supply. The numerous discoveries of oil added to the belief that this effective and useful resource was a gift from the Earth to man that would simply never run out. That may be true for our lifetimes, but it won’t stay that way for long. The supply of oil is not infinite. One day, the world will run out, and that day is approaching.

So far, the theory of Peak Oil is seen as just that — a theory. But the growing number of supporters of this theory shows us the reality of the situation. We most likely will not see the day when all the world’s oil wells simply run dry. But we will be around for the shock to our economic system when they are unable to meet the increasingly growing demand. As the supply of oil dwindles, as well as the expectations on increasingly lower supplies, the price for oil will begin to skyrocket. We’ve already seen the first steps of this being taken. In January 2008, the price per barrel of oil reached the previously unthinkable level of $100.

$100 oil was a record, and would have been a surprise to many speculators just a year or two earlier. But now those same speculators are becoming less naive. The problem of running out of oil is not one that will just go away, and the price will continue to rise as the supplies shrink.

Another reason for limited supply of oil is the profit-driven orientation of the governments that control many of the world’s oil reserves. Members of the Organization of the Petroleum Exporting Countries (OPEC) have a great control over the supply of the oil we use every day. However one feels politically about OPEC’s control, the truth is that in order to maximize profits, OPEC reserves the right to limit the supply of oil if it feels that the price is dipping. This artificial price control almost guarantees us that the price of oil will never significantly decline.

This news may be bad for millions of Americans trying to gas up their cars, but it is great news for anyone investing in oil. The companies in the oil business are some of the most profitable in the world. For example, in February 2008, Exxon Mobil Corp. posted record earnings for the fourth quarter of 2007. The earnings, $11.66 billion, were not just a record for the company; they were the biggest quarterly earnings ever posted by a single corporation in U.S. history. To give you an impression of how much these oil companies can profit, that record broke the previous mark that was also set by Exxon, in 2006.

Demand for Oil

Staying with the theme of elementary economics, world demand for oil also dramatically shifts its price. As we all know, Americans are currently held hostage by the need for oil. No matter how much public transportation or carpooling we all take advantage of, the price of oil is constantly being worked into our budgets. From the food we buy to the bags we use to take it home, the American consumer is paying the cost of oil all the time.

This is also true in many emerging foreign economies. Countries such as China and India have the largest populations on the planet. Until recently, the economies of these countries lacked any sort of real comparison with our own. But now things have changed. The governments and citizens of China and India have awoken in the 21st century, and a thirst and need for the world’s oil have been some of the consequences of their economic arousal.

Millions of new drivers in China and India are now among the millions of oil-demanding people in the world. Aiding their need for this oil has been the introduction of extremely inexpensive automobiles marketed specifically for these emerging economies. Recently, the Indian car company Tata released a $2,500 four-person sedan marketed toward Indian drivers who do not yet own a car. As more and more Indians begin driving, the cost of oil and gas will continue to rise. The effects will be felt all over the world — even here in the United States. This means more demand for oil at a time when we are clearly running out. The price of oil will now be pushed forward from both sides of the equation, and the oil companies sitting on this gold mine will keep raking in record profits.

How to Take Advantage

OK, so the supply and demand for oil is a problem — there’s no doubt about that. But if so many people are making money from this situation, how can you, too? There are a few different ways, each carrying a different level of risk.

The most obvious way to invest in oil is to hold shares of a particular oil company. For example, if you held shares of Exxon, you would be making a profit right along with it. The only problem with this approach is that it is far too narrow, and also very expensive. As I write, the price for a single share of Exxon is hovering around the $87 mark. As high as that is, following the record profits announcement, it is still $8 less than the 52-week high. A single oil company is an expensive game to break into, and even when things are going well, there are so many outside factors that the potential for losses is higher than ideal.

So if one company is too risky and expensive, how about some sort of composite investment? That is where the new and fashionable world of exchange-traded funds (ETFs) comes in. With certain ETFs, you can own a basket of different oil-producing companies, and as their prices move up and down, so will your investment.

The best part about owning shares in an Exchange Traded Fund is the diversification that comes with it. The principle of asset allocation is one of the most powerful tools in the history of investing. It earned economist Harry Markowitz the Nobel Prize, and has brought incredible wealth to scores of investors. An ETF lets you diversify your investment over an entire industry so that you can expect steady and decent returns over a large period.

ETFs are a more flexible and controllable tool than a traditional mutual fund. These baskets of related stocks are sold together as one single shares so that you don’t have to worry about micromanaging your entire portfolio. While you have that safety and ease that comes from a basket of stocks, you don’t have to worry about a giant albatross around your neck for a significant amount of time either.

Unlike traditional mutual funds, ETFs allow you the freedom to trade throughout the year, month, or even a single day. You’ll never have to make any sort of long-term commitment. It gives you a way to properly manage your investment while spreading the risk and concentration of your investment around.

Top Oil Exchange Traded Funds

Oil Services HOLDRs (OIH)
OIH tracks 18 of the biggest oil companies in the world. Some of the main holdings in the OIH portfolio are Schlumberger Ltd., Baker Hughes Intl., and Halliburton Co. The success of these companies, as well as of the other holdings of OIH, dictates the success of the fund. When you hold shares of a fund like this, you have diversified your investments across a wide array of companies, while still keeping your money focused on the performance of one sector.

iPath S&P GSCI Crude Oil Total Return Index (OIL)
Another fund to take a look at is one that directly tracks the price of oil. A fund like this is the iPath S&P GSCI Crude Oil Total Return Index (OIL). This fund is directly derived from the West Texas intermediate crude oil futures contract traded on the New York Mercantile Exchange. A fund like this is not nearly as diversified, but it does still shield you from some of the risks that are found in OIH. For example, you are investing only in the speculated price of oil. You have no ties to any companies and cannot be affected by their management, profits, expenses, or any other unforeseeable actions that could help or hurt a company’s performance.

Of course, no investment is without risk. The world is currently looking for alternative energies to help move us away from this expensive oil. But until that happens, one thing is for sure: The world needs oil, and we seem to be willing to pay anything to get it. An investment in oil is not one that can’t lose, but surely, the potential for gains is staggering.

Jamie Ellis for Whiskey and Gunpowder

The Daily Reckoning