Profit from the End of Cheap Oil with this ETF

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Author: Jonas Elmerraji

We’re well on our way to $200 oil. Are you ready?

Turn on CNN, Fox News, or CNBC, and you’re all but guaranteed to see a panel of “experts” who are betting on cheap oil. They’re making a huge mistake. Now more than ever oil is poised to rocket back up to triple-digit prices â€" and the investors who make smart bets now are going to make a fortune in the process.

Americans are getting misled about the oil crisis that we’re really facing. Despite media contortions blaming speculators in the futures market for overpriced oil, today’s spot prices are seriously skewed lower than they should be right now. While it’s absolutely true that speculation fueled oil’s run-up to $147 last summer, the pundits leave out the fact that oil’s intrinsic price is set to the rise regardless of supply and demand.

Prices that aren’t based on supply and demand… What kind of market is this?

The Simple Secret to Rising Oil Prices

One of the reasons oil is pushing higher now is the fact that the cost of extracting and processing oil has been rising over the course of the last few years. “Peak oil” is a frequently mentioned justification for the growing cost of oil extraction. Under the peak oil theory, as we pump the good, easy to find oil out of the ground, we’re left with lesser quality oil that’s deeper in the earth and more difficult (and expensive) to extract.

But peak oil is more than a theory; it’s a certainty.

Some oil experts believe that oil may have peaked back in 2005. If that’s true, it means that as time goes on the price of oil will continue to climb astronomically. That said, the evidence that worldwide oil production has already peaked is anecdotal at best.

Worldwide Oil Production

The chart above shows worldwide oil production from 1960 to 2005. While crude oil production reached new highs in 2005, we’re currently in a place similar to the late 1970s where oil saw a short-term “false peak” then continued to climb. And for every expert that says we’ve already hit oil’s production peak, there are two that say we have reserves to last us decades more.

But that doesn’t change the fact that the cost of oil is quickly rising for producers. Could it just be a case of poor budgeting?

Right now, a handful of Middle Eastern nations are in a serious predicament. Despite access to one of the most precious commodities in the world, places like Saudi Arabia, Dubai, Qatar, and Oman are at serious risk of posting big budget deficits for 2009. For some, like Saudi Arabia, it would be the first deficit posted in almost a decade… For others, like Qatar, this would be the first budget deficit in the country’s history. With oil margins lower than ever, they’re spending themselves to death. And over-spending isn’t relegated to the oil producing nations. Oil producing companies are feeling the hurt as well right now.

In the last nine months, oil giant Exxon Mobil (NYSE: XOM) saw its profits drop 73% to $0.92 per share. That’s a colossal tumble for a company that just a few months before announced the largest annual profit of any company in U.S. history.

Before the oil boom took off, the average operating cost for extracting a barrel of oil was $38, but in the last several years, the bottom line break-even price for a barrel of oil has averaged $87.24 â€" that means that in order for companies like Exxon and Chevron to report a profit from their oil production divisions, they need to see oil prices 22% higher than they are now.

But it gets worse…

Between 2002 and 2008, oil prices rose steadily â€" at a rate of nearly 18% every year. With projections of $100 oil in the late 2000s (like we saw last year), oil companies and producing nations grew their obligations, building new facilities and spending nearly 60% more on exploration of new oilfields. Those huge expenses are going to have to be priced into each barrel of oil going forward, raising those out of reach breakeven costs even more.

Why High Oil Costs Mean High Oil Profits for Investors

Even though the cost of oil (and its intrinsic price) has little to do with supply and demand, those two market forces are more or less what drive the market price of oil. In the past year, we saw oil prices fall as far down as $33.87, a painful spot for the oil companies and producing nations that I mentioned earlier. That artificially low price hasn’t lasted long…

As long as making a profit on oil continues to be difficult for companies, we’re going to see the playing field contract alongside oil production. Middle Eastern countries will have two choices: tighten their belts and cut spending, or pressure OPEC to cut production and increase their margins.

And as that happens, supply will contract in an environment where market prices are finally going to reflect fundamental problems in the producers’ cost structures.

Make no mistake â€" high oil prices aren’t going to throw the world into anarchy. Nor are we facing another Great Depression at the hands of $150 oil. That’s because even if the price of oil were to double from current levels, the average American household would still only spend approximately 2% of its income on oil â€" including everything from gasoline for your car, to the fertilizers and fuels used to bring the produce you buy to the grocery store.

While higher-priced oil would mean a moderate squeeze for family budgets, it wouldn’t represent a major change in lifestyle as long as high-priced oil continued to be in high supply (as it was in 2008).

Decades from now, a number of factors will likely shift the need for expensive oil. As new technologies, untested reserves, and better efficiencies enter the energy marketplace, it’s totally possible to envision the average cost of oil production to drop into the sub-$20 range. But that’s all a very long way off… What’s abundantly clear now is the fact that $70 oil isn’t sustainable in the medium term.

The Only Oil ETF Worth Investing In

There are a large number of oil and oil-related ETFs trading on the market right now â€"including funds that invest in oil futures and those that hold shares of oilfield service companies. But investing in oil through companies that service oil producers is a risky play; as the Exxons of the world continue to see their margins evaporate, they’ll be unlikely to enter into many major development obligations that these companies live on.

Right now, there are only three oil futures ETFs trading on the market: the U.S. Oil Fund ETF (NYSE: USO), the PowerShares DB Oil Fund ETF (NYSE: DBO) and the iPath S&P GSCI Crude Oil Total Return Index ETN (NYSE: OIL).

But of the three, only one stands out as a good investment right now…

For starters, the iPath fund isn’t actually an ETF at all â€" it’s an exchange-traded note (ETN) -- a debt security that’s linked to changes in the crude oil commodity markets. Instead of directly investing in oil futures (like the two ETFs do), this ETN is basically a promise from the issuer that they’ll track the performance of oil. That fact adds a lot of risk to OIL â€" to be precise, it’s known as counterparty risk â€" because the investment’s performance isn’t just tied to oil, it’s also tied to the financial health of the issuer. We’ll pass on this one…

Commodity ETFs have taken a lot of heat recently because they don’t perfectly track their underlying commodities. In the last 4 months, for example, the spot price of crude oil has risen 36%, while USO has only rallied 28%. One of the biggest reasons for the huge tracking error is what’s known as “roll yield”. Because futures have expiration dates, USO’s administrators have to constantly trade in their old futures for new ones. Unfortunately, because of the way future prices change over time, they often post a small loss on each position as they roll into the next futures contract.

As time goes by, this roll yield adds up to a big discrepancy between the performance of oil and the performance of USO.

But negative roll yields aren’t a problem for DBO. This ETF, which is based on the Deutsche Bank’s Optimum Yield Oil Index, uses the an optimum yield formula to replace expiring futures contracts with contracts that have the highest possible positive roll yield. And even with the added yield advantage, DBO’s expenses are 37% cheaper than USO’s.

While even DBO can’t track the spot price of oil perfectly, the ETF is the only fund worth considering if you want to invest in oil. And the technicals suggest that right now is the time to open a position …

Maximize Your Oil Profits with Smart Timing

For the past five months, DBO has been in a sustained uptrend from its March lows. Currently, there are several very bullish indicators that suggest DBO is going to keep up â€" or accelerate â€" its rally. First, onto the chart:

DBO has been trading in a fairly well-defined channel since March, and while this ETF’s current share price is sitting toward the midpoint, a recent bounce off of its 50-day moving average (DBO’s average price over the trailing 50 days) means that the price has a safety net to keep it from tracking back down to the lower bound of the channel.

Translation: DBO will continue to push higher…

Another bullish signal right now is the crossover of the 50-day moving average over the 200-day moving average. That intersection is a leading signal that means a large positive change is underway in this ETF. Given that this is taking place during a big bullish move, it’s a very strong positive signal for traders.

Fibonacci retracements are a tool used by technical analysts to determine key points of support and resistance using mathematically significant numbers. DBO has bumped off the vertical blue Fibonacci lines six times in its latest rally â€" which tells me that this ETF is highly influenced by these levels. Right now, it has just broken out above its most recent high (and the 0% retracement level on the graph above). That’s a significant development because it means that there aren’t any obvious stumbling blocks left for DBO to hit.

All of that said, I’d like to see a healthy pullback to either the lower bound of the price channel or either the 50 or 200-day moving averages before taking a position in this ETF.

As usual, the options on this ETF have a much higher profit potential than buying the ETF itself can provide. If your risk tolerance is higher, there are a number of DBO options with a decent trading volume right now.

Cheers, Jonas Elmerraji

Jonas Elmerraji is the editor of the Rhino Stock Report and a contributor to The Penny Sleuth, which offers unbiased commentary from expert analysts and authors about hot penny stocks.