Investing in Energy: How ETFs Offer Easy Commodity Access

Thanks to the growth of exchange-traded funds (ETFs) in recent years, ownership of energy-sector commodities has become more accessible. These commodities include crude oil and products refined from it, such as gasoline and home heating oil, natural gas, coal, kerosene, diesel fuel, propane and carbon credits.

Commodity ETFs usually track the price of a commodity or group of commodities in an index by using futures contracts, which are legal agreements to buy or sell a commodity at a predetermined price at a set time in the future. Investment returns on commodities ETFs are not usually influenced by the overall direction of the stock market the way that other ETFs is because they seek to track commodities prices, not energy sector stocks.

For investors who own stock-heavy portfolios and seek to increase diversification and inflation-hedge potential, some energy sector exposure may be beneficial. However, it's a good idea to have a long-term horizon for such investments because they can be volatile over brief periods.

Potential Benefits of Energy Commodity ETFs

Energy has recognized value all over the world, with demand for energy commodities keeps growing in industrializing emerging markets such as China and India. Because this value does not depend on any nation's economy or currency over time, most energy commodities have held their values against inflation very well. Energy prices tend to move in the opposite direction of the U.S. dollar, increasing when the dollar is weak. This makes energy ETFs a sound strategy for hedging against any dollar declines.

Backwardation is the most complex (and least understood) benefit of some energy commodity ETFs. These ETFs place most of their assets in interest-bearing debt instruments, such as short-term U.S. Treasuries, which are used as collateral for buying futures contracts. In most cases, the ETFs hold futures contracts with close delivery dates, which are also known as "short-dated" contracts. As these contracts approach their delivery dates, the ETFs roll into the contracts with the next nearest date. 

Most futures contracts typically trade in contango, which means that prices on long-delivery contracts exceed short-term delivery or current market prices. However, oil and gasoline have historically done the opposite, which is called backwardation. When an ETF systematically rolls backward-dated contracts into one another, it can add small increments of return, called roll yield, because it is rolling into less expensive contracts. Over time, these small increments can add up to significant sums, depending on patterns of backwardation or contango.

Types of Energy Commodity ETFs

Energy ETFs can be divided into three main groups: single contract, multi-contract and bearish. Single Contract ETFs participate principally in single futures contracts. For example, the Invesco DB Oil Fund (DBO) participates in the West Texas Intermediate (WTI) light sweet crude oil futures traded on the New York Mercantile Exchange (NYMEX).

Multi-contract ETFs offer diversified exposure to the energy sector by participating in several futures contracts. The iShares S&P GSCI Commodity-Indexed Trust (GSG), for example, has about two-thirds of its total weight in the energy sector and the remaining one-third in other types of commodities. It tracks one of the oldest diversified commodities indexes, the S&P GSCI Total Return Index. The Invesco DB Energy Fund (DBE) is a pure energy sector fund that's diversified across commodity types. It participates in futures contracts for light sweet crude oil, heating oil, Brent crude, gasoline and natural gas. The ETF seeks to track an index that optimizes roll yield by selecting futures contracts according to a proprietary formula. 

Since energy sector commodities can be volatile, some investors may want to bet against them at times with bearish ETFs. The ProShares UltraShort Oil & Gas ETF (DUG) is designed to produce two times the inverse, or opposite, the performance of the Dow Jones U.S. Oil & Gas Index. This means that if the Dow Jones U.S. Oil & Gas Index drops 1% for the day, DUG should theoretically rise 2% for the day. Another short ETF is the ProShares Short Oil & Gas ETF (DDG). It's similar to the DUG, but it is only designed to produce one times the inverse performance (-1x) of the Dow Jones U.S. Oil & Gas Index.