How Oil ETFs React To Falling Energy Prices

By David Fabian, FMD Capital | September 03, 2014 AAA

The summer months are generally regarded as a seasonal period of strength for oil prices and energy stocks. The considerable demand for energy consumption peaks with the summer driving season, as cyclical forces impact this heavily traded commodity. In addition, this year we are in the midst of geopolitical unrest throughout the Middle East and Eastern Europe. Both of these regions are well-known producers of crude oil and natural gas. 

The combination of these factors should be pressing energy prices higher amidst fears of energy supply concerns coupled with seasonal demand trends. Instead, the opposite effect is occurring and it’s impacting several key ETFs. (For related reading, see: What Determines Oil Prices?)

The United States Oil Fund LP (USO) just recently slid to new five-month lows as a result of energy reports showing ample demand in the U.S. and abroad. USO tracks the daily price movement of West Texas Intermediate light, sweet crude oil by investing in commodity futures contracts on the NYMEX exchange. The objective of USO is to allow ETF investors the ability to invest directly in crude oil without the need for a commodity futures account.

USO is the largest and most heavily traded oil futures ETF. It currently has over $740 million in total assets and trades nearly 3 million shares per day, making it extremely liquid. However, investors in this style of fund should be aware that its structure as a limited partnership requires that shareholders receive a K-1 at the end of every year. This will create an additional burden that will need to be addressed at tax time. An alternative investment with a similar objective is the iPath S&P GSCI Crude Oil Total Return ETN (OIL), which is structured as an exchange-traded note and does not require any additional tax forms. 

The Upside (and Downside) of Falling Energy Prices

For most consumers, falling energy prices is exactly what they want to hear. It means lower prices at the gas pump and reduced utility costs as well. However, the same can’t be said of investors in energy stocks that tend to be highly correlated with the price movement of commodities. 

The Energy Select Sector SPDR (XLE) has also recently experienced a modest slump as a result of falling crude oil prices impacting the revenues of large integrated energy companies. This ETF invests in a mix of direct oil producers and energy equipment providers such as Exxon Mobil Corp. (XOM) and Schlumberger NV (SLB). 

XLE currently has over $11 billion in total assets and charges an expense ratio of just 0.16%. The holdings in this ETF can be negatively impacted on cutbacks in refinery production and unexpected increases in energy supply reports. However, these stocks also retain the crown of being some of the largest and most profitable companies in the world. 

One energy sector that has been extremely resilient in the face of summer volatility has been master limited partnerships. The Alerian MLP ETF (AMLP) recently hit a new 52-week high and currently pays a dividend yield of 6%. 

MLPs typically are less sensitive to commodity price fluctuations because they derive a significant portion of their revenues from infrastructure leasing and development. These companies operate pipelines, terminals, transportation, and storage of crude oil and natural gas. In addition, their legal structure allows them to return the majority of profits to shareholders as dividends. This makes them a favorite among income investors searching to strengthen the yield of their portfolio.

The Bottom Line

From a technical perspective, the chart of crude oil is indicative of a bearish head and shoulders top which could still be a motivating factor for further downside price movement. In addition, the price has also broken the key 50 and 200 day moving averages; however those areas could ultimately prove to be excellent entry points if a reversal takes place. No matter which stock index or commodity index you elect for inclusion in your portfolio, be sure to place a stop loss in an intuitive place to protect against further downside movement. Limiting your risk while also being agile should insure a more successful outcome. (For more, see: How To Trade The Head And Shoulders Pattern.)

Looking for new ETF growth ideas?  Download our latest opportunistic growth special report here.

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