Guide to Oil ETFs - TheStreet

Guide to Oil ETFs

There is still no ETF offering physically backed oil, but investors have a choice of several futures backed ETFs or futures tracking ETNs that deliver a range of tax and strategy options.
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NEW YORK (TheStreet) -- Last year when I wrote a guide to oil ETFs, there were 12 options for investors. Half of those were short, double long and double short ETFs, while six were various long strategies. One year later, two of these funds, the MacroShares Oil Up and Oil Down, have closed due to lack of investor interest, while the double long PowerShares DB Crude Oil Double Long ETN (DXO) closed to avoid running afoul of CFTC position limits. United States Commodity Funds also launched a new short ETF product (DNO).

Although it might prove popular, there is still no ETF offering physically backed oil and unlikely to be one. Instead, investors have a choice of several futures backed ETFs or futures tracking ETNs that deliver a range of tax and strategy options.

ETF vs ETN.

At the top level, the difference between the ETFs and ETNs lies in their tax status. The oil ETNs are taxed the same as stocks. The holding period determines whether capital gains are taxed at short-term or long-term rates, and the holder can decide when to trigger a taxable event by selling the ETN. ETFs are set up as partnerships and they issue K-1 forms. Gains and losses are taxed at 60% long-term, 40% short-term, regardless of how long the fund is held, based on the gains and losses in the underlying futures contracts. This means a holder is liable for taxes even if they do not sell the ETF.

Along with the difference in tax status comes the credit risk of holding an ETN. These are structure as debt and the credit worthiness of the financial institution issuing the security may have a bearing on the performance of the fund. During the financial crisis, some ETNs traded at discounts due to fear about the solvency of the issuing firm.

Aside from the ETF and ETN distinction, the main differences between the funds are the timing of contract rolls.

U.S. Oil

(USO) - Get Report

, for instance, rolls contracts each month, while

PowerShares DB Oil

(DBO) - Get Report

follows the Deutsche Bank Optimum Yield Index that opts for the best contract to minimize contango or maximize backwardation.

Long Oil.

For going long oil, there are five choices: USO, DBO,

U.S. 12 Month Oil

(USL) - Get Report

,

iPath S&P GSCI Crude Oil Total Return Index ETN

(OIL) - Get Report

,

PowerShares DB Crude Oil Long ETN

(OLO) - Get Report

.

Performance varies with these funds due to contango in the oil futures market. Although less extreme than in 2009, recent contango was enough to cause a 52-week low in USO in May 2010, for instance, despite the fact that oil spot prices have not made a 52-week low. Although not exactly the same, OIL does behave very similarly to USO and also hit a new 52-week low during oil's recent sell-off. DBO and OLO both use the Optimum Yield index, they only differ in that one is an ETF and the other an ETN. Finally, USL also uses a monthly roll strategy, but differs because it holds the next 12 months of oil futures contracts. This allows the fund to reduce the cost of contango and it behaves more similarly to DBO than to USO.

The cost of contango is easy to see in the graph above. It compares a continuous WTI crude futures contract to the price of USO. A rising line means crude oil futures prices are outperforming USO, and it clearly shows that in 2009, during "super contango", USO vastly underperformed crude oil. The chart also shows that a bit of extreme contango returned at the end of April 2010.

Compare the first chart chart with the one above, for DBO, which tracks an index that tries to minimize contango. The fund still suffered in February and March of 2009, but that was after briefly outperforming. OLO has the same chart as DBO, and USL shows similar performance.

In sum, investors looking to go long oil with an ETF should look first to DBO, then USL. For an ETN, look first to OLO. Over very short periods of time, USO and OIL may be better bets due to their larger liquidity and the fact that they will perform similarly during normal market conditions. For a day trader, USO or OIL may be best, but as the holding period increases, these funds quickly become more risky and an ETF such as DBO becomes a much better choice.

Leveraged Long.

For investors who want to double their oil bet, there's only one choice since

the closure of PowerShares DB Crude Oil Double Long ETN (DXO), namely

ProShares Ultra DJ-UBS Crude Oil

(UCO) - Get Report

. The shuttering of DXO highlights the regulatory risk faced by investors in these products and it remains to be seen whether or not UCO falls into the crosshairs of the CFTC or SEC.

UCO offers double the daily return in crude oil and is therefore subject to the same compounding errors as other leveraged ETFs. The product should only be used for short periods and is unsuitable for all but the most aggressive and experienced investors.

Short Oil.

If investors want to short oil without leverage, there are two choices:

PowerShares DB Crude Oil Short ETN

(SZO) - Get Report

and

U.S. Short Oil

(DNO)

. The difference with SZO the other PowerShares oil funds is that the short funds do not use the Optimum Yield index. DNO uses the same strategy as USO, except that it shorts the near-month futures contract. Performance between the two has been similar in the long-run.

DNO has higher volume than SZO. Recently, volume picked up when oil declined, but earlier in the year, volume in SZO sometimes fell to below 10,000 shares per day, while that was roughly the low volume for DNO. Therefore, unless oil enjoys a sustained decline that leads to volume increases, DNO is the better choice.

Leveraged Short.

Finally, there's the option of going double short in oil with

PowerShares DB Crude Oil Double Short ETN

(DTO) - Get Report

and

ProShares UltraShort DJ-UBD Crude Oil

(SCO) - Get Report

. These two have equivalent dollar volume over the past three months and their performance has been similar for most of the time, except for the period of "super contango", when DTO outperformed. DTO also resets monthly, as do all the PowerShares crude oil funds, but SCO resets daily.

Don Dion is president and founder of

Dion Money Management

, a fee-based investment advisory firm to affluent individuals, families and nonprofit organizations, where he is responsible for setting investment policy, creating custom portfolios and overseeing the performance of client accounts. Founded in 1996 and based in Williamstown, Mass., Dion Money Management manages assets for clients in 49 states and 11 countries. Dion is a licensed attorney in Massachusetts and Maine and has more than 25 years' experience working in the financial markets, having founded and run two publicly traded companies before establishing Dion Money Management.

Dion also is publisher of the Fidelity Independent Adviser family of newsletters, which provides to a broad range of investors his commentary on the financial markets, with a specific emphasis on mutual funds and exchange-traded funds. With more than 100,000 subscribers in the U.S. and 29 other countries, Fidelity Independent Adviser publishes six monthly newsletters and three weekly newsletters. Its flagship publication, Fidelity Independent Adviser, has been published monthly for 11 years and reaches 40,000 subscribers.