Thinking about an oil ETF?

Owning a chunk of the action in “Texas tea” was a winner for Jed Clampett, but will sinking your invest dollars in an oil ETF be more likely to land you in a Beverly Hills mansion or looking like Jethro on the back-end of a scheme gone wrong?

As is always the case, the answer depends on who you ask.

How do oil ETFs work, anyway?

We recently provided a little overview of how an exchange traded fund (ETF) works.  When it comes to a commodity like oil, things are ever-so-slightly different.  The best explanation I’ve found came from ETFdb.com.  They explain:

At a high level, oil ETFs function just like any other exchange-traded product: they track an underlying index. But unlike traditional equity ETFs that hold a basket of securities comprising the underlying indexes, most oil ETFs achieve exposure in a very different manner. Because physically buying and holding most oil and gas products is prohibitively expensive (and in some cases, like natural gas, nearly logistically impossible), oil ETFs instead generally invest in near-term futures contracts on the underlying commodity to gain exposure to prices. While this strategy may track spot prices fairly closely in certain environments, it may be way off in others

That’s a great explanation because it explains what’s really in the fund, how it ties to the oil market and the reasons why it can be a hit-or-miss proposition.  But it doesn’t answer the question of whether or not you should be investing in an oil ETF.  In an effort to provide a balanced overview, we’ll look at both arguments.

Some reasons to consider investing in an oil ETF

A commentary at Zantrio makes a near-term recommendation for oil ETF investment.  There’s not much explanation for the thumbs up other than the usual “my sources tell me” and “all indicators point to…” rhetoric.  Interestingly, the piece notes that a strengthening dollar and other factors may actually have a negative longer term impact on oil, but the author thinks there’s still space for some upward movement.

The argument detailed by Josh Lipton at Minyanville is more persuasive.  He notes that Morgan Stanley analysts and others are bullish on oil and oil ETFs and that their excitement stems from two observations.  First, there’s a sense that we could be looking at a 4% growth rate for the GDP in 2010, which will not only increase short-term demand, it will also refocus attention on limited supply issues tossing even more fossil fuel on the “this stuff is running out and, thus valuable” fire.  Additionally, the article notes that demand for oil has been fairly inelastic, especially in many foreign economies, meaning that there’s plenty of space before a price correction would be necessary.

Some reasons to pass on oil ETFs

That same Lipton article also notes that there are plenty of analysts who disagree with the Morgan Stanley assessment and who don’t believe the fundamentals in place to predict a justifiable rise in the price of crude.  In other words, it may or may not go up but based on reality and logic, it should probably be cheaper.  The upticks in price are the work of rampant speculation, according to this perspective.  I think we’ve all seen enough bubbles pop over the last few years to be wary of another speculation-driven, overvalued investment opportunity.

Another piece at ETFdb notes that moves toward stabilizing post-war Iraq’s oil industry could lead to a bounce in overall output.  That would have a negative impact on prices.  That analysis points to one potential reason to be concerned about long-term increases in oil prices, but concedes that changes in Iraq are unlikely to have much of a near-term impact on oil ETF values.

So, is it a good idea to buy oil ETFs right now?

Well, I’d recommend reading all of the above-noted material, the sources they cite, the sources those sources cite, etc. before sinking as much as a Sacajewa dollar into an oil ETF.  There are interesting arguments on both sides and when you combine those differences of opinion with the inherent volatility of oil and the fact that oil ETFs don’t always actually track to real market prices, it feels like a crapshoot.

What’s your opinion?  Is it time to invest in oil?  If so, do you think that an ETF is the best way to make the move?