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Energy ETFs Still Have Room to Fall

Billy Fisher
11/25/08

The price of crude oil broke below $50 a barrel last week as commodity and energy ETFs continued on a downward spiral.

The United States Oil Fund(USO QuoteCramer on USO - Stock Picks) has fallen 67% since crude hit a record of $147 a barrel in July. Natural gas has also taken its share of hits in recent months. The United States Natural Gas Fund(UNG QuoteCramer on UNG - Stock Picks) has plummeted 58.5% since July.

Other ETFs in the commodity and energy industries that are reeling include the SPDR S&P Oil & Gas Exploration & Production ETF(XOP Quote - Cramer on XOPStock Picks), the SPDR S&P Oil & Gas Equipment & Services ETF(XES QuoteCramer on XESStock Picks) and the Energy Select SPDR ETF(XLE QuoteCramer on XLEStock Picks), which have dropped 46.1%, 58.3% and 49.2% this year. These declines compare to a 47.7% retreat by the S&P 500.

After such precipitous drops in price, one has to wonder where the bottom is for some of the ETFs in this space. “Oil probably has at least another 10% to 15% of downside,” said Keith Springer, president of Springer Financial Advisors, in an interview on Nov. 12, when oil was trading about $56 per barrel. “I would look for oil to close below $50 a barrel before I would buy it.”

Tony Welch, a portfolio manager at Sarasota Capital Strategies who specializes in ETFs, also believes things could get worse before they get better for energy ETFs. “People need to understand that we are in a bear market,” he said. “Energy is one of the more uncertain sectors right now.”

Welch cautions against trying to pick a bottom in energy. “We are in unprecedented times,” he said. “Some of the energy ETFs tend to look like they are bottoming out, but we need to see improvements, first in the general market and second in the sector. XLE is forming a technical wedge that could go either way.”

Top holdings of XLE include Exxon Mobil(XOM QuoteCramer on XOMStock Picks), Chevron(CVX Quote - Cramer on CVX - Stock Picks), ConocoPhillips(COP Quote - Cramer on COPStock Picks), Devon Energy(DVN Quote - Cramer on DVNStock Picks) and Transocean(RIG QuoteCramer on RIGStock Picks).

Agriculture’s allure

Joe Clark, managing partner at the Financial Enhancement Group, finds the PowerShares DB Agriculture Fund(DBA QuoteCramer on DBA - Stock Picks) to be one of the more attractive commodity ETFs. “We definitely believe DBA is the best way for an individual to get into the space,” he said. “If I am going to bet on a commodity right now, I am going to bet on something that feeds me.”

Clark cautions investors to be on the lookout for signs of deflation in the short term, especially in light of the declining price of oil. “A risk in a commodity culture is deflation,” he said. “If a commodity price falls below the input cost, then you have to run for cover.”

He notes that oversaturation would prove to be a major drag for commodities. “When there is deflation, all of the inventory is sold as quickly as possible,” Clark said. “Such a scenario would flood the market and drive prices down.”

Bailout factor

The TARP government program may have been initially intended to stabilize the financial markets, but Springer believes that, in time, it also could have implications for commodities. “Nobody knows for sure if it is going to work,” he said. “If it does, we will see a lot of money flooding the market and then inflation could be our next problem.”

For investors considering ETFs to protect against such an outcome, Springer likes the PowerShares DB Commodity Index Fund(DBC), the PowerShares DB Oil Fund(DBO) and the iPath Dow Jones-AIG Commodity Index Total Return ETN(DJP).

“Because of the amount of liquidity coming into the economy in the coming months, $700 billion from the U.S. and $600 billion from China, the economy will grow with tremendous inflation and, thus, demand for commodities,” he said.

Welch agrees that there will be a continued demand for commodities, but notes there may be new sources. “We are always going to need energy,” he said. “It may not always be oil, though. Clean energy is becoming more of a story with the new administration coming in.”

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