3 Ways to Profit From Falling Oil Prices

“There’s no question that the earth is going to run out of oil within the next 10 years”, read the Peak Oil investment pitch that came across my desk. Citing a variety of scientists and academics, it appeared that these guys really did their homework when preparing the presentation.  It painted a downright frightening picture of a world without oil and, frankly, was quite compelling. The fund was promoting a strategy of buying oil call options that were expected to make investors wealthy with just a small investment — that is, if the Peak Oil premise was correct. 

#-ad_banner-#The claims seemed outrageous to me, but I decided to take a closer look at the concept before dismissing these guys as kooks. 

Here’s what I discovered… 

Very few commodities engender such radically different opinions than oil. On one hand, there are the Peak Oil bulls and on the other, those who believe the earth itself is continually manufacturing oil in an endless cycle of supply. Peak Oil is the theory that the earth will soon run out of oil, pushing prices into the stratosphere, while the other side believes oil is a renewable resource that can never deplete.  

Obviously, neither one of these extreme views is completely correct. As in most things, the truth lies somewhere in the middle. 

My thoughts are, while oil supplies are not infinite, there is plenty to go around for the foreseeable future. And even better news, there are still ways for investors to profit

Technology evolves, enabling oil to flow from the most unexpected places. Witness the current boom in North American production as an example. Taking the very long term view as an investment strategy is a fool’s game. Oil is a commodity that is meant to be traded in the relative short term. In other words, go with the trend and don’t cling to any one opinion.  

Right now, oil’s trend is down. Prices have plunged 25% since May 1, with benchmark West Texas Intermediate Crude dipping below $80 a barrel. 

The downtrend was triggered by the global economic slowdown, particularly in the euro zone. The slowdown combined with increased North American production, Saudi Arabia countering every Iranian manipulation ploy, and the shift to greener energy sources should continue to depress prices.  

What is the best way to play the downtrend in oil? I am partial to three exchange-traded funds (ETFs) that short oil.

1. ProShares UltraShort Oil & Gas (NYSE: DUG)
This inverse ETF’s goal is to mimic twice the inverse performance of the Oil & Gas Index by investing in derivatives the manager believes will provide this kind of correlation. It is up about 12.4% for the year and boasts assets of over $68 million.

2. iShares Dow Jones Transportation Average (NYSE: IYT)
It makes sense that transportation stocks will benefit from dropping oil prices, as they are a major cost for trucking firms and the like. This ETF is designed to profit from a rising transportation index. It is up about 5% for the year and holds more than $560 million in assets.

3. ProShares Short Oil & Gas (NYSE: DDG)
This ETF is similar to DUG, but without as much risk. Its performance is designed to be inverse to the Oil & Gas Index without the benefits and dangers of leverage. The ETF is higher by about 6.4% for the year and holds $8.37 million in assets.

Risks to Consider: Oil is a commodity, like any other. It can and does have sharp counter-trend moves that can be dangerous to your portfolio if you are over-leveraged. Be particularly cautious holding DUG, as the double leverage may cut both ways. Position sizing rules and stop losses are even more critical when trading commodities, so use caution.

Action to Take –> I like all three of these ETFs for playing oil’s downside. If your timeframe is very short-term, then the double-leveraged DUG makes solid sense right now or to fade sharp counter-trend moves. If your investment time frame is longer, or you don’t want to have such a high degree of risk, then the other two ETFs (IYT or  DDG) fit the bearish view on oil just fine. Remember, the lower line of my Value Buy Zone is the initial stop loss. Once violated, you should consider selling.