Crude Oil ETF Basics – What You Need To Know

Many investors are seeking the ability to add commodity exposure to their portfolios. This can be difficult for most home-based investors to achieve through traditional methods. Since the advent of exchange-traded funds, anyone with a brokerage account can now easily jump into the commodities market. When it comes to trading commodities, there isn’t an easier method than by utilizing commodity ETFs.

Oil Pump

Why Invest in Oil?

Crude Oil is a commodity that affects every consumer on the planet. Its by-products are used to generate electricity and heat, fuel global transportation, and to make plastics and composite materials that are used in a wide variety of household goods. Because oil is so integral to daily life, the benchmark price is watched closely by not only active commodities investors, but by everyday common consumers. This has become even more true in the last few years because of the skyrocketing price of oil, and the subsequent spike of the price of crude oil’s by products.

Everyone is familiar with the price of a gallon of gasoline. Whether you fill up your gas tank weekly, monthly, or somewhere in between, the rising gasoline price has impacted every facet of family life, from vacations to buying groceries. The price of oil (and subsequently the price of gasoline and other crude oil based products) is dependent, like everything, on supply and demand. There are events that can cause dramatic shifts to the supply of oil, such as:

Natural Disasters

We can all remember hurricane Katrina, and the havoc that it caused on the gulf coast. Because of that natural disaster, many of the oil refineries located in Louisiana were damaged or destroyed completely. Because of this, the price of crude oil, as well as natural gas, skyrocketed. Other natural disasters could cause similar cuts to the supply, increasing prices.

OPEC Production Levels

The production of oil from the Middle East is based on what this cartel decides. If there is a weak global demand for oil (like what can happen during a worldwide recession), OPEC can cut production to spur a shortage and increase in price.

Alternative Energy Production

With the increased focus on becoming less reliant on oil, technological advances in the alternative energy sector have been significant. Solar, wind, geothermal, hydroelectric, and bio-fuel power sources have increased in popularity and demand across the world. If these energy sources become viable long term replacements for oil, the demand for oil could drop. This is a future development, as the alternative energy sources in question have major obstacles and prohibitively high start-up costs associated with them.

Conflict in the Middle East

The Middle East is a hot bed of conflict. Many Middle Eastern countries are almost completely supported by the production and exportation of oil, which adds fuel to the tension. Civil war, civil unrest, and all out conflict can cause a stoppage of production form countries that are involved.

Increased Global Demand

The global population continues to rise, and with it, the demand for oil based products. There are many countries that are emerging from under-developed 3rd world nations into industrial powers, such as Brazil, China, and India. The later two countries make up a third of the world’s total population, and many are being introduced into the world of automobiles and planes.

Government Regulation

Because of the popularity of oil ETFs and the recent surge of money into this market, the size of these funds has gotten to the point that many regulatory agencies are concerned about the speculative behavior of these funds. In the news, it is not uncommon to hear that the price of oil is fluctuating not based on supply or demand, but because of speculative investing. Regulatory agencies are investigating the possibility of stepping in and limiting the amount of positions and contracts that specific funds can hold. This could limit the ability of a fund to grow.

Supply and demand is at the forefront when it comes to pricing of any commodity on the market, so an increase in demand (whether it be from global increases or natural causes) or a decrease in supply (from a storm knocking out production) will give the price upward correction.

So why invest in crude oil? One specific benefit of gaining exposure to crude oil in your portfolio is the ability to hedge against inflation. With an increasing global demand of oil-based products, positions of crude oil in your portfolio will help you keep up with increased inflation.

How to Invest in Oil

Trading crude oil the traditional way meant gaining access to a pit trader who would then allocate money towards natural gas futures contracts. Mutual funds that have positions in crude oil lack transparency and are riddled with fees. ETFs allow you the ability to bypass brokers and pit traders altogether, as well as increase the transparency in your investments.

ETFs in crude oil can track different aspects of this commodity, such as:

  • Crude oil exploration
  • Crude oil drilling
  • Crude oil refining and production
  • Crude oil supplying

Diversified crude oil ETFs will include all of these at some pre-determined percentage. Exploration is a higher risk investment than supply; so many diversified funds spread the risk out based on their specific goal.

Oil investments can also be broken down into two other categories of ETFs:

  • Direct
  • Indirect

Investing directly in crude oil means investing in the physical commodity (through futures contracts, options, exchange traded notes). Investing indirectly in crude oil means investing in equities of companies that deal in the exploration, drilling, refining, production, and supply of oil. Since these companies profit based on the price of oil, your investment will mirror the benchmark price of crude.

There are several different methods for trading crude oil ETFs. These oil investment methods are discussed below.

Crude Oil Index Funds

Index ETFs are funds that track a specific index. For example, as the Dow Jones €”UBS Crude Oil Sub-Index goes up or down, so do specific ETFs that track this index.

Crude Oil Futures Funds

Most crude oil ETFs trade in near term futures contracts. Futures have a direct influence on crude oil prices. The crude oil ETF purchases the front month futures contract on the NYMEX, for example. When the front month is within 2 weeks of expiration, they will ‘roll’ the contract into the next month (or sell the position from the front month and buy positions in the next month). This ensures that your position in crude oil will always be ‘long.’ Contango risk, or the possibility of the long term contracts being priced higher than near term contracts, exists with this trading strategy.

Leveraged Crude Oil Funds

Leveraging is one of the great tools that often comes with ETF investing. There are many funds that attempt to double, triple, or even quadruple your return. They achieve this through margin investing. For example, the ProShares Ultra DJ-AIG Crude Oil (UCO) ETF tracks the Dow Jones USB Crude Oil Sub-Index, but is leveraged 2x in an attempt to double your return. It is not uncommon to find a 2x crude oil ETF or an oil ETF 3x option among the different leveraged oil ETF options on the market.

Inverse Crude Oil Funds

What if you want to bet against the price of crude oil and make money on it? There are two ways to go about doing this. You can short a crude oil index ETF, which would mean that as the index price decreases, you can sell the stock short and make a profit. There are also inverse oil ETF options available. These funds are basically doing the short selling for you, as they track the inverse of the index fund (basically a short oil ETF). Leveraging can also be applied to this investing strategy (for example, you could buy a fund that tracks the inverse of the crude oil index, but triples the return of the short position).

Trading Crude Oil ETF Options

Buying or selling call or put options for a crude oil ETF is another method for trading these funds. This is a great way to hedge against a future spike or severe drop in oil price, since you don’t actually have to allocate money until the strike price has been met.

Editor’s note – leveraged investing, margin investing, and options investing include substantially increased risk. Be sure you do your homework and understand exactly how your are allocating your money.

Crude Oil ETF List Of Options

United States Oil Fund (USO)

Founded in 2006, USO seeks to reflect the performance of the spot price of West Texas Intermediate (WTI) light, sweet crude oil. USO invests in futures contracts for WTI light, sweet crude oil, other types of crude oil, heating oil futures, gasoline, natural gas and other petroleum based-fuels that are traded on exchanges. It also invests in other oil interests such as cash-settled options on oil futures contracts, forward contracts for oil, and OTC transactions that are based on the price of oil. USO is an example of a futures contract related oil ETF.

PowerShares DB Oil Fund (DBO)

DBO was founded in 2007 and tracks the price and yield performance of the Deutsche Bank Liquid Commodity Index – Optimum Yield Oil Excess Return. The index is a rules-based index composed of futures contracts on Light Sweet Crude Oil (WTI) and is intended to reflect the performance of crude oil. DBO is an example of an index ETF.

ProShares Ultra DJ-AIG Crude Oil ETF (UCO)

UCO, founded in 2008, seeks to provide daily investment results that correspond to twice (2x) the daily performance of the Dow Jones €”UBS Crude Oil Sub-Index. The fund invests primarily in any one of or combinations of Financial Instruments, including swap agreements, futures contracts, and options on futures contracts or forward contracts with respect to the applicable benchmark. It invests other assets in cash or in cash equivalents and/or U.S. Treasury securities or other high credit quality short-term fixed-income or similar securities that serve as collateral for the financial instruments. UCO is an example of a leveraged oil ETF.

ProShares UltraShort DJ-AIG Crude Oil ETF (SCO)

Also founded in 2008, SCO seeks to provide daily investment results that correspond to twice (200%) the inverse (or opposite) of the daily performance of the Dow Jones €”UBS Crude Oil Sub-Index. The fund invests in any one of or combinations of the financial instruments (swap agreement, futures contracts, forward contracts, option contracts) with respect to the applicable fund’€™s benchmark. It invests other assets in cash or in cash equivalents and/or U.S. Treasury securities or other high credit quality short-term fixed-income or similar securities that serve as collateral for the financial instruments. SCO is an example of an inverse leveraged oil ETF.

ProShares UltraShort Oil & Gas ETF (DUG)

DUG was founded in 2007 as a leveraged inverse ETF. The investment seeks daily investment results that correspond to twice the inverse (-2x) of the daily performance of the index. The fund invests in derivatives that should have similar daily return characteristics as twice the inverse (-2x) of the daily return of the index.

ProShares Ultra Oil & Gas ETF (DIG)

Founded at the same time as DUG above, DIG seeks daily investment results which correspond to twice (200%) the daily performance of the Dow Jones U.S. Oil & Gas Index. The fund invests in equity securities and derivatives that should have similar daily return characteristics as twice (200%) the daily return of the index. Like DUG, DIG is a non-diversified ETF.

PowerShares DB Crude Oil Double Short ETN (DTO)

DTO was founded in 2008 and tracks the price and yield performance of 200% (2x) of the inverse (or opposite) daily performance of the Deutsche Bank Liquid Commodity index – Optimum Yield Oil Excess Return. The fund allows investors to take a short view on the performance of the index. The index is a rules-based index composed of futures contracts on light sweet crude oil (WTI) and is intended to reflect the performance of crude oil. DTO is an ETN rather than an ETF, and has credit-associated risks involved.

Indirect Oil ETFs

iShares Dow Jones U.S. Oil & Gas Ex Index ETF (IEO)

IEO was founded in 2006 and tracks the price and yield performance of the Dow Jones U.S. Select Oil Exploration & Production Index. The fund invests 90% in securities of the underlying index. The index measures the performance of the oil exploration and production sub-sector of the U.S. equity market. It includes companies that are engaged in the exploration for and extraction, production, refining, and supply of oil and gas products. IEO is an example of an ETF that tracks an index, and is focused on oil exploration and production. This is a good way to indirectly invest in oil.

iShares Dow Jones U.S. Oil Equipment Index ETF (IEZ)

IEZ, founded in 2006, tracks the price and yield performance of the Dow Jones U.S. Select Oil Equipment & Services Index (the ‘€œunderlying index’€). The fund invests 90% of its assets in securities of the underlying index and in depositary receipts representing securities of the underlying index. It may invest the remainder of its assets in securities not included in the underlying index. The fund may lend securities representing up to one-third of the value of the fund’€™s total assets (including the value of the collateral received). IEZ is another indirect method for gaining exposure to crude oil.

Market Vectors Oil Services ETF (OIH)

Founded at the tail end of 2011, OIH tracks the price and yield performance of the Market Vectors US Listed Oil Services 25 Index. The fund invests at least 80% of its total assets in securities that comprise the fund’s benchmark index. Its benchmark index is comprised of common stocks and depositary receipts of U.S. exchange-listed companies in the oil services sector. OIH is another example of an indirect ETF for gaining oil exposure.

These are a few of the options when it comes to crude oil ETFs on the market today, and this list demonstrates a good starting point to research for an investor looking to add crude oil commodity exposure to their portfolio. Search the crude oil ETF symbol for the respective fund that catches your eye for more information.

In Conclusion

Adding commodity exposure through ETF investing to your portfolio is a great way to add diversity, as well as inflation protection. With the many advantages of ETF trading (intraday investing, low cost, transparency of assets), you can increase your bottom line with respects to investment results. Because of the uncertainty relating to future oil prices, this can be a risky market play. Make sure you do your homework before adding one of the above mentioned ETFs to your portfolio. Remember that adding exposure to crude oil is a good method to hedge against a sour economy. Good luck and happy investing!

Disclosure

I have no positions in any ETFs or ETNs mentioned, and no plans to initiate any positions within the next 72 hours.

Disclaimer: Please remember to do your own research prior to making any investment decisions. This article is not a recommendation to buy or sell any securities or stocks, and is the opinion of the author.

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