The Best Way To Invest In Energy Right Now

By David Sterman
February 06, 2013

The world was shocked when the Brazilian energy corporation Petrobras (NYSE: PBR) announced in 2007 the discovery of a massive oil deposit.

Buried deep under the Atlantic Ocean, the Tupi oilfield, due east of Rio De Janeiro, was said to contain 5 billion to 8 billion barrels of oil.

Quite suddenly, this semi-nationalized Brazilian oil company became one of the hottest energy stocks in the world. Petrobras' shares tripled in value from the summer of 2007 to the summer of 2008, pushing its stock market value north of $200 billion.

But this story doesn't have a happy ending. Getting to all that oil proved costly, and it's taking a lot longer to generate production than had been hoped. A once-hot energy stock has since cooled off.

The rise and fall of Petrobras illustrates why many investors who want exposure to the energy exploration industry are sidestepping direct purchases of such stock and buying exchange-traded funds (ETFs) instead. These funds take a broader approach, owning a group of companies that will benefit from the sustained growth in the oil and gas industry.

In fact, some ETFs directly focus on energy prices, bypassing the companies involved in energy extraction, refining and marketing. Let's take a closer look.

The Blue Chip Producers

The Energy Select Sector SPDR (NYSE: XLE) is a favorite choice for many. This fund charges a measly 0.18% annual expense fee and lets you own a little piece of the industry's best companies. Here's a look at the top five holdings.

The third-largest holding in this ETF, Schlumberger (NYSE: SLB), isn't even an energy producer. The company provides a wide range of services to the top energy producers and tends to benefit when energy prices are firm and energy drilling activity is robust. This fund also owns many of the U.S. firms that are focused on the natural gas opportunities buried in our country's various shale regions.

Other ETFs that focus on energy producers include:

  • First Trust AlphaDEX Fund (NYSE: FXN)
  • iShares Dow Jones U.S. Energy Sector Index Fund (NYSE: IYE)
  • SPDR S&P Oil and Gas Exploration & Production ETF (NYSE: XOP)

The Commodity ETFs

As the Petrobras example shows, exploring for oil doesn't always reap sudden profits. It's a cost-intensive business, and profit growth can be elusive while companies ramp up their capital spending. That's why some investors prefer to own ETFs that more squarely focus upon the prices of oil and natural gas. As an example, we saw natural gas prices rise more than 50% since the spring of 2012, but companies that produce natural gas didn't see their share prices rise nearly as quickly.

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A quick peek at the U.S. Natural Gas ETF (NYSE: UNG) shows how investors directly profited from spiking natural gas prices.

Just like this fund, there is a corresponding ETF that focuses on crude oil. The U.S. Oil ETF (NYSE: USO) tracks the price movement of crude oil; it delivered robust gains when oil prices shot up in early 2008. Of course, the converse is also true. A sharp pullback in energy prices won't impact the companies' stock prices nearly as much as these commodity-focused ETFs.

Why would a typical investor make such a seemingly bold bet on energy prices? Many people use ETFs like these as a simple hedge to protect other investments in their portfolio. For example, an investor that has a large stake in an airline carrier like Delta Airlines (NYSE: DAL) or Southwest Air (NYSE: LUV) would suffer deep losses if crude oil prices surged and airlines became unprofitable. They'd at least gain some benefit by buying these ETFs, which would rise in price if crude oil prices rallied.

Getting Some Leverage

ETF investors are also moving more aggressively into "2X" or "3X" funds. These funds move at twice or three times the rate of the underlying commodity price. For example, the ProShares Ultra Dow Jones Crude Oil ETF (NYSE: UCO) is a "2X" fund, which means it will rise 20% if crude oil prices rise 10%.

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Investors also can position themselves against rising energy prices by buying "inverse" funds, which move in the opposite direction of the underlying commodity price. For example, the PowerShares DB Crude Oil Short ETB (NYSE: SZO) moves in the opposite direction of crude oil prices, while the ProShares UltraShort Dow Jones-UBS Crude Oil ETF (NYSE: SCO) will move in the opposite direction of crude oil prices -- at twice the speed.

Lastly, ETFs that focus on companies operating our nation's energy pipelines have become popular. Many of the companies in this industry are structured as Master Limited Partnerships (MLPs), which means they don’t have to pay income taxes at the corporate level. They are known for impressive dividend yields. A popular ETF in this segment is the JP Morgan Alerian MLP Index ETN (NYSE: AMJ), which currently offers a dividend yield in excess of 5%.

The Investing Answer: For many investors, the era of stock-picking is coming to an end. Instead of identifying the best company in an industry, many investors now simply prefer to glean exposure to the best industries. In the energy sector, that's proven to be an especially popular strategy, as investors tire of trying to figure out whether ExxonMobil (NYSE: XOM), Chevron (NYSE: CVX), Petrobras or some other firm will be next year's industry leader. Chances are, most of these firms will flourish in tandem, making the ETF path more savvy.

(Author's note: Two funds cited in this article are referred to as "ETN" or exchange-traded note. They are fundamentally similar to ETFs, though they don't own company stock directly and instead own financial instruments, such as bonds issued by the fund's underwriter).