Investors Get Energized With Energy ETFs for 2010

By: Ron_Rowland

Energy is big business here in Texas. Just about everyone in the state knows someone in the industry, if they aren’t employed in it themselves.

In fact, energy is big business everywhere!

Crude oil, natural gas, gasoline — our civilization can’t live without them. So it’s no surprise that energy exchange traded funds (ETFs) are also big business.

Today I’m going to give you a brief overview of the ETFs in this sector. As you’ll see, energy is a surprisingly diverse industry.

Energy is big business everywhere.

Big Oil: Diversified Energy ETFs

Let’s start at the top, with the generic “energy” ETFs. Almost without exception, these funds are dominated by a handful of big multinational oil companies. You know the names: ExxonMobil (XOM), ConocoPhillips (COP), ChevronTexaco (CVX), British Petroleum (BP) and a few others.

Consider SPDR S&P Energy (XLE). Just two companies — XOM and CVX — account for around a third of this ETF’s assets. Vanguard Energy (VDE) looks much the same.

Is this a problem? Not necessarily. Huge companies like ExxonMobil are actually very diversified, operating many different business units in a variety of locations around the globe. Their sheer scale gives them some big advantages.

On the other hand, it’s usually a good idea not to put too many eggs in one basket …

Some ETF sponsors try to reduce the concentration in Big Oil with different weighting strategies. Rydex S&P 500 Equal Weight Energy (RYE), for instance, holds the same stocks as XLE, but only allocates 2.5 percent — 3 percent to any one stock.

Energy Service: Let Big Oil Pay You

Energy service ETFs get paid by Big Oil.

I’m especially fond of energy service stocks. Unlike the multinationals, these companies don’t own properties or produce energy for themselves. But they do a lot of the work — and get paid well for it. They run drill rigs, perform seismic tests, build pipelines, fly helicopters, and many other sundry tasks.

ETFs that specialize in energy service have performed well over the years. What’s the downside? When oil prices retreat, the major producers cut back on their activities. Thus the service companies can be hit hard. But a lot of their revenue comes from long-term contracts, so they can be worth the risk.

Here are two of my favorite energy service ETFs …

• iShares Dow Jones U.S. Oil Equipment & Services (IEZ)
• SPDR S&P Oil & Gas Equipment & Services (XES)

Exploration and Production

There’s another subset of ETFs that narrows in on companies that focus on the exploration and production (E&P) of energy resources. Many of the companies in this group are the small, independent oil companies that take on projects too small or risky for the big guys to consider. Those that succeed are often sold to the major multinationals, or developed as joint ventures.

Here are a couple of ETFs that specialize in the E&P subsector …

• SPDR Oil & Gas Exploration & Production (XOP)
• iShares Dow Jones U.S. Oil & Gas Exploration & Production (IEO)

Commodity-Based Energy ETFs

Not all energy ETFs own energy stocks. Some cut to the chase by trying to track the price of energy commodities. In theory, this makes sense. After all, the companies in ETFs, such as XLE, may go up along with oil prices, but not always. So why not cut out the middleman?

Unfortunately, it’s not quite that easy …

Some of the best-known commodity ETFs are fiendishly complicated instruments that don’t always move as expected. Moreover, as I wrote in my column back in September, these funds are under attack from regulators and may have to radically change the way they operate. Some use an exchange-traded note, or ETN, structure that is riskier than it looks.

Am I down on all commodity-based energy ETFs? Not at all. I’m just saying they are not as magical as some people think. Funds like U.S. Oil Fund (USO) and PowerShares DB Oil (DBO) can be very profitable. Just use them with caution.

The Next Wave: Alternative Energy ETFs

You don’t have to be an expert to notice that the world seems to be running out of oil. I’m not an alarmist about this. But I do see the need to look for other sources of energy. So do plenty of other folks. That’s why a sort of gold rush is underway in the alternative energy sector.

The world needs new sources of energy.

ETF sponsors have created several funds to meet this need. Some are more generalized within the alternative energy business, while others target specific niches. Here are a few examples …

• Claymore Solar ETF (TAN)
• First Trust ISE Global Wind Energy (FAN)
• Market Vectors Nuclear Energy (NLR)
• Market Vectors Global Alternative Energy (GEX)
• Market Vectors Solar Energy (KWT)
• PowerShares WilderHill Clean Energy (PBW)
• PowerShares Global Wind Energy (PWND)

The ETFs in this group often tend to be full of risky, small-cap stocks. On the other hand, their upside potential is enormous if oil prices move above $100 again.

Today I’ve barely scratched the surface of the massive energy sector. But as you can see, if you’re ready to take the leap, energy ETFs give you a lot of choices.

Best wishes,

Ron

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