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ETF Talk: Taking a Crude Path

May 19, 2010
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The devastating oil spill off of the Louisiana coast has been followed by declining oil prices and increasing questions among investors about the future direction of the commodity. However, the oil spill does not appear to be nearly as much of a factor in oil prices right now as reduced demand and the strengthening U.S. dollar. While the price of oil currently is sliding, a potential buying opportunity will arise once the commodity starts a sustained recovery.

Clearly, oil is not a commodity that you want to invest in while it continues to fall. However, I am watching for when oil will begin to turn upward. When it occurs, I already have an exchange-traded note (ETN) in mind that you may want to consider. The investment that I am looking at to take advantage of the inevitable recovery in oil is the iPath S&P GSCI Crude Oil Total Return Index ETN (OIL).

The iPath ETNs are senior, unsubordinated debt securities issued by Barclays Bank PLC that are linked to the total return of a market index. In the case of OIL, the index is the S&P GSCI Crude Oil Total Return Index. The ETN is designed to provide investors with cost-effective exposure to crude oil, as measured by the index.

Today, benchmark crude for June delivery continued a three-week drop when it slid $1.19 to $68.22 a barrel on the New York Mercantile Exchange. Earlier today, prices had slipped to $67.90 to hit the lowest point for an oil contract since Sept. 30. On May 3, a barrel of oil sold for $87.15 — the highest price in 18 months. Oil prices briefly rallied toward $72 a barrel Tuesday but ultimately slumped further due to growing investor concerns that the European debt crisis could disrupt the global economic recovery. Do not be surprised to see a number of short-lived rallies in the days ahead.

During the past few weeks, prices for WTI — the benchmark U.S. oil contract traded on Nymex — plunged by more than 20% amid investor worries that big government spending cuts and rising government debt will curb economic growth, as well as demand for oil.

A $1-trillion bailout package announced last week by the European Union and International Monetary Fund has failed to reassure investors and did not prevent the euro from falling to a four-year low of $1.2237 on Monday. The rising dollar has hurt oil prices, since crude has become more expensive to foreign buyers who do not pay in dollars. The euro’s slight uptick in the past couple of days has not stemmed the drop in oil prices.

With the current bearish market sentiment, there is no telling how much further oil prices may drop. Demand actually has been aided by increased consumption in faster-growing economies such as China and India. It is possible that U.S. demand could rise in the second half of 2010, if the budding economic recovery gains momentum.

However, austerity measures announced by debt-laden European countries such as Greece will hurt economic growth and consumption in that important region of the world. Demand elsewhere does not seem to be assuaging the concerns of oil investors who are worried about Europe’s ongoing woes.

As I look at the future of OIL, there are several reasons for my optimism:

First, the massive BP oil spill in the Gulf already has been factored into the price of oil. It also is likely that efforts to combat the spill will result in at least modest success in the weeks ahead.

Second, energy is a great way to hedge against impending inflation. And, oil is a fine alternative to the most common inflation hedge — gold and other precious metals — which recently hit record levels before pulling back today.

Finally, as we are about to enter the summer months at the end of the Memorial Day Weekend, we typically see significantly more driving and, thus, more demand for gasoline. Of course, forecasters expect gasoline prices to ease between now and Memorial Day in the United States, so that situation could keep OIL trading close to its current lows for the year — at least for a while.

If you want my advice about buying and selling specific ETFs, including appropriate stop losses, please sign up for my ETF Trader service. As always, I am happy to answer your questions about ETFs, so do not hesitate to email me by clicking here. You may see your question answered in a future ETF Talk.