Why Buy an Energy ETF?
As an individual investor, you will have more access to energy-sector commodities because of the growth of ETFs in recent history. In 2006, the United States Oil Fund (USO) ETF was the first to be introduced in the United States. This investment fund is the most popular in terms of trading volume and asset size. Since ETF’s, unlike currencies, have the volatility of many stocks, the leverage is a 1:1 ratio. If oil prices increase by 10% in a given period, you should expect your ETF investment, theoretically, to increase by 10%. One share of USO would be roughly equivalent to a barrel of oil.
Benefits of Energy ETFs.
Portfolio Diversification
Experts recommend energy commodities to balance portfolios that are primarily composed of high volatility stocks. This risk management strategy involves combining low-correlating assets. In general, this means that the portfolios should have a balance of investments that are not affected by the same factors and thus, will not move in the same direction simultaneously.
For instance, a portfolio of only stocks in one particular industry may be depleted if a news report is released that negatively affects the market and precipitates a crash. Diversification will cushion the blow if one particular industry or commodity is affected.
Oil or energy commodities have low correlation to the performance of U.S. stocks. Between 2002 and 2007, the correlation between oil futures and the S&P 500 Index was -0.31. A perfectly negative correlation would be a -1 and a perfect correlation would be a 1. For diversification, the correlation should be closer to -1 to protect your assets. Trading software and brokers can help determine correlation.
Participation in Global Growth
Energy supplies affect the entire world and thus, you need to study the conditions of energy in the world to make a sound investment. The United States comprises 25 percent of the world’s daily consumption of oil, which is currently 85 million barrels of oil daily. Each year, according to the International Energy Agency, U.S. oil consumption increases by three percent. The worldwide reserves are depleting and demand grows until alternative fuel sources become prominent. Saudi Arabia, once a leader in oil production, is watching their reserves dwindle to low levels.
Oil consumption in China has slowed compared to recent years. Prior to this, the demand for energy commodities was high in China and India. Politically, countries such as Russia, Iraq, Iran, Nigeria and Venezuela are volatile. Though they have oil supplies, they are unreliable sources of oil. An extensive knowledge of the conditions of the oil industry is vital for selecting the appropriate fund and making the right decision about entry and exit points into the market.
Backwardation
According to experts, this concept is one of the least understood benefit of trading energy ETFs and commodities. Using this strategy, interest-bearing debt instruments such as United States Treasuries are selected as the primary vehicle for investing assets. These ETF’s are then used as collateral for purchasing futures contracts.
Oil and gasoline commodities perform opposite of most futures contracts. Most futures contracts consist of long-term delivery contract prices that exceed short-term delivery prices, instead of short-term delivery prices exceeding long-term delivery contract prices that are typical of oil and gasoline. The concept is called “backwardation.” Small returns are gained when an ETF “rolls” backwardated contracts. The investors profit as the incremental gains or “roll yield” add up from rolling into less expensive contracts.
Inflation Hedge
Investors should include energy commodities in their portfolio because they do not depend upon the nation’s economy or currency. Inflation does not affect energy commodities as much for this reason. Crude oil prices have increased 6.5% from 1950 to 2007. Energy prices also tend to move in the opposite direction of the dollar. When the dollar is weak, the prices increase.
Summary
Energy ETFs, like gold, are good ways to balance a portfolio when the market is unpredictably volatile. As an investor, you should consider historical data and current news to determine the best energy ETF for your portfolio.