Study of Signals

[j.c.]

ETF Focus (Oil - USO)
Roll Out the Barrel

By Lawrence Carrel Published: April 5, 2006

ATTENTION ASPIRING Jed Clampetts: Texas tea is about to bubble up on the Amex.

With crude futures recently hitting a two-month high of $67.90, excitement is building for the launch of the United States Oil Fund, the first exchange-traded fund tied to the price of a barrel of oil. The ETF had been slated to begin trading Monday under symbol USO on the American Stock Exchange, but it has yet to receive final regulatory approval from the Securities and Exchange Commission. It's now expected to debut by next week.

Virtually all ETFs are registered as index funds, which means they passively track the performances of specified stock indexes. USO is a bit different. It's structured as a commodity pool, so it isn't governed by the more restrictive rules of the Investment Company Act of 1940. The new ETF's pricing will be determined by the performance of a basket of futures contracts for light sweet crude oil, as well as other energy derivatives that are listed on the New York Mercantile Exchange. Like all ETFs and unlike mutual funds, USO will price throughout the day just as stocks do.

USO will be one of the only pure-play commodity ETFs on the market. Launched in 2004, StreetTracks Gold Trust (GLD: 58.66, +0.33, +0.6%) was the first, but it holds actual gold bullion. StreetTracks Gold was followed by the similarly structured iShares COMEX Gold Trust (IAU: 58.77, +0.27, +0.5%). A silver ETF is expected to debut later this year. USO has the advantage of dealing in futures contracts rather the physical commodity, so it'll save big on transportation and storage expenses. Its management fee is projected to be 0.5%, according to regulatory filings.

USO comes to market at an opportune time and has the potential to attract brisk interest. Many commodities prices have doubled or more over the past two years, but individual investors have been limited in their ability to play the price of oil. Short of opening a futures trading account or buying oil-company stocks outright, the closest the Average Joe could come to betting on crude was purchasing a broadly diversified mutual fund or ETF that reflected the performance of a basket of energy-sector stocks. USO will lift that limitation by offering direct — not to mention risky — exposure to oil prices.

"I know what I'm going to make on a crude oil ETF because I can see what happens to crude futures," says David Fry, founder and publisher of ETFDigest.com, an online investment newsletter. "[The Energy Select Sector SPDR (XLE: 56.33, +0.91, +1.6%) exchange-traded fund is] subject to the caprices of the stock market and to the earnings of the companies, factors which are not directly tied to the price of crude oil. Also, the XLE will have companies in different sectors of energy, such as refining and equipment, so it's much more of a mixed picture."

USO offers the added attraction of mitigating portfolio risks.

"People think just by diversifying into other stock-market sectors that they are diversified, when all these sectors are going in the same direction," says Fry. "But oil can go into any direction just by supply and demand, and it often moves inversely to stocks. You want that kind of asset in a portfolio because it reduces risk. That also makes it good for people who want to hedge, or just outright speculate as a short bet."

Black Gold or Fool's Gold?
Of course, making a profit on USO comes down to whether oil prices continue to climb. As Hurricane Katrina pounded the Gulf Coast and shut down offshore rigs and refinery operations, crude hit an all-time peak of $70.85 a barrel on Aug. 30. By December, oil slid below $60 a barrel before resuming this year its choppy climb back toward the record.

"I think it will go higher and might reach $100 a barrel in about a year," says Michael Fitzpatrick, vice president of energy risk management at Fimat USA, the commodity brokerage arm of French bank Societe Generale. "We've been lucky so far. There haven't been any major glitches in the market, but I'm just waiting for the other shoe to drop."

Fitzpatrick says with the U.S. economy continuing to grow even with oil at $60 or so a barrel and consumer sentiment high, this actually gives the market room to drive the price even higher. Considering gasoline is approaching record highs, demand in the U.S. still hasn't diminished. And even though crude inventories are expected to swell, the refinery infrastructure is already too taxed to handle the current supply fast enough. International instability is yet another factor. All in all it's a recipe for higher crude prices this summer.

"All the elements that brought us to this level are still with us. The growing demand in China and India is not going away," says Fitzpatrick. "Nor do I see geopolitical tensions diminishing. I'm not expecting an outbreak or reasonableness in the Middle East anytime soon."

Iran, the world's No. 2 producer of oil behind Saudi Arabia, continues to spar with the U.S. and United Nations over its uranium enrichment program. Then there's Venezuela, the third-largest producer in the Organization of Petroleum Exporting Countries, which Fitzpatrick says "is aching to back Iran in a conflict with the West. That, in turn, will increase competition for the available oil." About one-quarter of the Nigerian oil market is being hampered by rebel attacks in the Niger Delta region. Nigeria is the sixth-largest oil producer in OPEC.

To some market watchers, the very introduction of an oil ETF is a sure sign that crude is peaking.

"This is a sucker's bet," says John Rutledge, chairman of Rutledge Capital, a Greenwich, Conn., private-equity investment firm. "There are people who invest for a living and those who do it as a hobby. And the latter tend to buy the thing that made money last year. After a two-year, massive commodity-market rally when anything you can lift or ship has gone up at least 100%, it's unlikely that will be reproduced going forward."

Victoria Bay Asset Management, which is managing USO, declined comment citing a quiet period ahead of the ETF's launch.

Commodities bulls, Rutledge says, are betting that China's strong growth will continue at its current rate. Even if it does he says he'd rather own a diversified set of companies that make money by doing something, rather than companies that own something like a commodity.

"The oil ETF will appeal to traders and someone hedging a portfolio of oil stocks, but I think a diversified commodity fund is better for individual investors that are putting together strategic asset-allocation portfolios," says J.D. Steinhilber, president and founder of AgileInvesting.com, an investment advisory firm based in Nashville that recommends and manages ETF-based portfolios.

The Deutsche Bank Liquid Commodity Index Tracking Fund (DBC: 24.07, +0.15, +0.6%), for example, debuted in February. It's an ETF that tracks a commodity index based on crude, aluminum, wheat and other commodities futures contracts. There are several mutual funds as well that are made up of the stocks of commodities companies. With so many options available, some observers question the wisdom of putting money at risk in such a specialized security like an oil ETF.

"We've been in a bull market for oil and are at the high end of the range, so there's potential for it to fall by a significant amount," says Steinhilber. "I would be more enthusiastic if the ETF came out when oil was $50 instead of $70. There is a speculative premium in oil that could come out at any time and leave investors with a bad taste in their mouths."

Then there's the ultimate, albeit unscientific, sign the time is wrong for an oil ETF. "BusinessWeek just did a cover story about oil," says Steinhilber, "and you know that's the kiss of death for an asset."

http://yahoo.smartmoney.com/etffocus/index.cfm?story=20060405&afl=yahoo