Are These Energy ETFs Best Bets for Oil and Nat Gas Price Changes?

How and ETF Investor can profit from Energy ETFs!

The world runs on energy; there is no getting around it.  The real question is, “What type of energy will be used?”  There are several types in demand, though the most in-demand resource is oil.  You hear about the price of a barrel of oil, how it influences the stock market, and how traders see the global markets reacting to the constantly changing price of oil. 

You also see how the world’s developed countries are attempting to secure their sources of oil.  This is why most people are watching the growing tensions in the Middle East between Israel and Iran.  Iran was one of the main suppliers of oil for much of the world, but over the past few weeks, many countries are cutting back on their imports of Iranian oil in an effort to curtail Iran’s nuclear program.  The world is not convinced of Iran’s claims that the nuclear program is for scientific research and power needs, but rather, think that Iran is trying to build nuclear warheads as weapons.  This is why Iran’s oil output is at its lowest level in 20 years according to the Wall Street Journal.

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This continuing crisis in the Middle East will likely continue to affect supplies of available oil, as well as the resulting price of oil itself.  OPEC (Organization of Petroleum Exporting Countries) claims that it can meet the world’s demands for oil without Iran’s supply, which will help to stem the price of oil from rising too much, but the Iranian situation is still a major concern for many investors around the world, as well as for every country on Earth in terms of national security.

The other main concern when it comes to oil is the fact that developing economies such as China and India are beginning to use more oil.  This is because more of their citizens are earning higher wages, leading to their ability to purchase vehicles that need oil to run.  As a result, more countries are placing demand on the planet’s oil supply, which will naturally increase the price of oil since the supply of oil is finite.  This is another major reason why the Iranian oil situation is being watched very carefully.

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Another energy source that is getting much attention lately, especially in the United States, is natural gas.  This is because natural gas is at its lowest price in the United States in 10 years.  This is due to the fact that there has been an explosion in the production of gas that is trapped in shale rock.  The United States wants to keep the price of its natural gas low, which is why it will likely set limits on exports of liquefied natural gas.

Natural gas isn’t just an important energy resource in the United States; it is an important energy resource throughout the world because it is considered to be one of the safest, cleanest, and most useful of all energy resources available.  Natural gas is useful in Europe and Asia as well; however, unlike the United States, European natural gas prices are not as low, and due to the fact that the U.S. is planning on saving most of its supply of natural gas for domestic use, European natural gas prices are forecast to remain higher than U.S. prices for the foreseeable future.  This could negatively impact the European economy, which is already in turmoil due to the problems in the EuroZone and the faltering economies in Spain and Italy.

According to the Wall Street Journal, if oil prices continue to remain high and natural gas prices remain low in the United States, there is certainly the potential for natural gas to gain market share in the transport sector.  For this to occur, though, multi-year investments and new infrastructure would have to occur in order to easily transform the natural gas into diesel fuel.  Therefore, the advantage that the United States could enjoy and the resulting increase in the market share for natural gas would not manifest itself right away.

The increasing demand for natural gas has led to a process known as “fracking.”  This process is a method of natural gas extraction that is used in deep natural gas well drilling.  Once a well has been drilled, millions of gallons of water, sand, and other chemicals are injected into the well site at a high pressure.  This pressure fractures the shale and opens up fissures that allow the natural gas to more freely move out of the well so that it can be collected and used.

The development of fracking is important because this has opened up new supplies of natural gas that were not previously available via traditional drilling methods.  This is a major reason why the United States has an abundance of natural gas, thereby deflating the price of U.S. natural gas as compared to the rest of the world’s supply of natural gas.

Fracking is not without its critics, however.  Scientific studies are attempting to determine whether fracking is responsible for earthquakes near the sites where fracking has taken place.  In Ohio, as was reported in the Los Angeles Times on March 9, 2012, the injection of wastewater from natural gas drilling into a disposal well was likely the reason why the surrounding area near Youngstown, Ohio experienced a dozen earthquakes between late December 2011 to March 2012.  The area was not previously known for seismic activity, raising suspicions that fracking is responsible for causing these earthquakes due to the water being forced into the well site at high pressures, not only forcing the natural gas from the shale, but also causing activity within the Earth that led to the earthquakes. 

While the reported earthquakes were no higher than 4.0, relatively minor on the Richter magnitude scale, it still raises concerns that fracking could cause greater damage in the future, especially if fracking is used repeatedly in specific locations, such as Eastern Ohio, Western Pennsylvania, and Western New York where there are many shale deposits holding natural gas deposits.

One other important energy resource is nuclear energy.  Germany and Japan were both heavily invested in nuclear energy.  However, Japan is reconsidering its investment in nuclear energy ever since the 9.0 earthquake and resulting tsunami on March 11, 2011 caused the nuclear disaster and resulting leaks of radiation.  The major concern and reversal of nuclear energy in Japan is due to the fact that many citizens and government officials are concerned that Japan’s nuclear reactors would not be able to withstand significant seismic activity, just as three reactors at the Fukushima Daiichi Nuclear Power Station partially melted down and another reactor’s fuel rods released radioactive material directly into the atmosphere and into Tokyo’s water supply.

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Due to the fact that Japan is so dependent on nuclear energy, however, Japanese Prime Minister Yoshihiko Noda has called for the phasing-out of nuclear power over several decades, not immediately.  Japan does not have viable energy alternatives at this time to be able to eliminate its dependence on nuclear energy immediately, but is something that the country of Japan is looking to do at some point in the future.

German Chancellor Angela Merkel has announced that Germany is shifting away from nuclear power and moving toward renewable energy, including wind power.  However, the plans have stalled due to differing interests within Germany itself.  The energy debate is looking to be a key issue in the general elections that will take place in 2013. 

For Germany to replace its 12,696 megawatts of power it receives from nuclear energy by 2022, it is estimated that Germany will have to create 15 power generation units, about 10,000 megawatts of power, through the rest of this decade.  The problem is that investors do not want to invest the billion euros it would take to create each of these power generation units without knowing for sure that the new power can be sold profitably. 

The fact that both Japan and Germany (the third- and fourth-largest economies in the world, respectively) are turning to other sources of energy besides nuclear energy to fulfill its electricity needs will put more of a strain on the supplies for other energy sources, including natural gas, renewable energy, coal, and electricity. 

In addition, this will give better bargaining power to countries that are major gas producers, including Algeria, Qatar, and Russia.  As a result, these countries can charge higher prices for the natural gas they produce.  This could really affect the European Union, as it has succeeded in recent years to reduce its dependence on Russian natural gas.  The reduction and eventual abandonment of nuclear power by Germany, as well as by Switzerland and Italy, could lead to the EU having to pay higher costs for Russian natural gas due to the greater demand for it by EU members.  This will lead to higher costs for electricity, since renewable energy is a considerably more expensive and less efficient source of energy as compared to nuclear energy.  This will not help the economic problems in the EU being faced by some of its members (Spain and Italy especially, with Portugal another potential country), potentially leading to a longer period of recession, and even depression, for the EU, which could lead to devastating economic consequences for the entire global economy.

There are several ETFs that focus on the world’s energy sources.  One ETF is OIL, which is the iPath S&P GSCI Crude Oil TR Index ETN (NYSEARCA:OIL).  This Exchange Traded Note is linked to the performance of the Goldman Sachs Crude Oil Return index.  Returns are earned via an unleveraged investment in the futures contracts made up of the index plus the Treasury bill rate of interest.  This index is derived from the West Texas Intermediate (WTIC) crude oil futures contract that are traded on the New York Mercantile Exchange.  As of the time of this writing, the NYSEARCA:OIL ETF was down 4.22%, trading at $24.52. 

Another ETF that focuses on the world’s energy sources is the United States Oil Fund LP  ETF (NYSEARCA:USO).  This ETF attempts to replicate the price performance of futures contracts on light, sweet crude oil that is delivered to Cushing, Oklahoma.  These contracts are usually considered by most to be the benchmark for U.S. crude oil prices.  You would want to invest in this ETF if you believe that oil prices are going to rise.  As of the time of this writing, the NYSEARCA:USO ETF was down 3.97%, trading at just under $38 at $37.29.

A third ETF that focuses on the world’s energy sources is the United States Natural Gas Fund, LP ETF (NYSEARCA:UNG).  Due to the BP Gulf of Mexico disaster that occurred in 2010 and the resulting concerns over the future of oil, many natural gas ETFs, including UNG, are becoming much more popular buys.  The fact that natural gas emits less carbon than other forms of energy and that many companies are investing considerable money into natural gas operations, natural gas ETFs are likely to be a strong buy for the foreseeable future.  As of the time of this writing, UNG was down 1.97%, trading at about $16.40.

A fourth ETF that tracks the world’s energy sources is the Energy Select Sector SPDR Fund ETF (NYSEARCA:XLE).  This ETF tracks the performance of the S&P Energy Select Sector Index, which closely tracks companies within the S&P 500′s Energy Sector.  This includes energy equipment, gas, and oil companies.  As of the time of this writing, NYSEARCA:XLE was down around 2.29%, still trading below $70.00.                                                                                 

The Vanguard Energy ETF (NYSEARCA:VDE) is another ETF that tracks the world’s energy sources.  This ETF attempts to track the performance of a benchmark index that measures the investment return of energy stocks, the MSCI US Investable Market Index (IMI)/ Energy 25/50.  This fund is non-diversified.  As of the time of this writing, this ETF was down around 2.20% and trading at $99.26.

The iShares S&P Global Energy Sector Index Fund (NYSEARCA:IXC) attempts to track those companies that Standard & Poor’s considers to be a part of the energy sector of the economy and important to the global market.  This index is a subset of the Standard & Poor’s Global 1200 Index.  As of the time of this writing, the IXC ETF was lower by 2.59%, trading at $36.63.

Executive Summary:

There is great concern over the world’s energy sources.  When it comes to oil, the continuing, rising tension between Israel and Iran is causing oil prices to increase due to the fact that the oil supply could be less because Iran does not want to export its oil to countries involved in imposing sanctions on it due to its nuclear program.

Additionally, to increase the pressure on Iran to stop its nuclear program, several countries, such as India, are eliminating Iranian imports of oil.  This is further reducing the accessible supply of oil, which will likely keep oil prices higher for the foreseeable future.  When it comes to natural gas, the United States has an abundant supply and an advantage of lower prices compared to Europe, but the uncertainty over “fracking” causing earthquakes could prevent the U.S. from fully taking advantage of that abundant supply.

When it comes to nuclear power, both Germany and Japan want to abandon nuclear power in the future due to the dangers shown by the earthquake and tsunami in March 2011 that resulted in radioactive material being released into the atmosphere.  This will cause more demand for other energy sources, including natural gas, which could favor major natural gas suppliers like Russia, and force the European Union to have to pay more for it.  With its current EuroZone problems and potential defaults by EU members Spain and Italy, this will only increase the chances of Europe being in a lengthy recession, which could negatively impact the world economy. 

Bottom Line: When it comes to energy ETFs, you want to invest in those ETFs that track energy sources that are bound to increase in price.  The best bets right now would be ETFs that track oil and natural gas due to the continuing tensions in the Middle East and the increasing demand for cleaner and safer natural gas.

John Nyaradi is the author of The ETF Investing Premium Newsletter.