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Commodities That Could Heat Up in 2011

Crude Oil

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Energy prices are poised to head higher in 2011, as investors bet on a global recovery. Crude oil has already made a strong recovery in 2010, up over 15% year to date and 25% from its February low of around $71 a barrel.

Several analysts are predicting oil prices could easily rise to $100 a barrel in 2011 as demand picks up and supply tightens.

Global oil demand in 2010 was its second strongest in 30 years, according to Barclays Capital analyst Kevin Norrish. Underlying demand in the U.S. also remains strong, Norrish notes, with oil demand in September increasing by 913,000 barrels/day, the highest monthly increase since 2004. The recent blast of cold weather is also likely to boost distillate demand.

Meanwhile, OECD crude oil inventories outside the U.S. have fallen below seasonal norms and overhang of U.S. oil inventories is declining, indicating tighter supplies in the near term. There could also be further upside surprises in the form of unseasonably cold weather and geopolitical risks.

How to Trade: Investors seeking direct exposure to crude oil might want to consider ETFs, but that could be tricky. ETFs such as the United States Oil Fund (USO) and iPath Crude Oil Index ETN (OIL) have performed terribly despite a rise in crude spot prices.

In the past two years, a phenomenon called contango has messed up returns for these oil ETFs. Contango means longer dated futures contracts are more expensive than those approaching expiration. That means funds buy at higher prices when they roll over the contract, a money losing proposition.

But now the opposite has happened. The futures contracts for oil are moving into backwardation, meaning near-month contracts are once again at a premium to longer dated ones. That makes this a better time to buy funds such as USO and OIL than in the past.

Still Morningstar analyst Paul Justice recommends buying a fund such as PowerShares DB Oil Fund (DBO) which uses Deutsche Bank's trademarked "Optimum Yield" indexing methodology to maximize gains or minimize losses posed by the implied roll yield. In other words, investors can get a long-term exposure to oil without having to worry about words like contango and backwardation and the daily dynamics of the futures market.

For investors who prefer to play the commodity rally through stocks, TheStreet contributor Daniel Dicker recommends integrated oil companies, with ExxonMobil (XOM - Get Report) as his top pick (see chart above). A more speculative play would be SandRidge (SD - Get Report), Dicker says, as it moves from natural gas to oil assets.

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