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Has Crude Oil's Rally Run Out of Gas?

Has Crude Oil’s Rally Out of Gas?
Ron DeLegge, Editor
June 10, 2009

SAN DIEGO (ETFguide.com) – Just in time for the summer travel season, oil and gas prices are heading higher. The price of the light, sweet crude oil contract for July delivery has neared $72, which is new high for this year. Can crude continue its upward march or has its rally run out of gas?

Generally, summer is a seasonally strong period for oil, but other factors are at work.

Supply and demand is a constant issue for all commodities including oil. The current perception is that oil demand will increase with stronger economic activity and that stability within the broader U.S. economy might be on the horizon. The other half of the perception equation is that actual supply of crude seems to be falling. Data from the American Petroleum Institute last week showed U.S. crude inventories dropped more than expected.

What else is boosting oil prices? Oil’s surge has coincided with corresponding weakness in the U.S. dollar. Because oil and most commodities are traded in dollars, a weak greenback means it takes more dollars to buy the commodity.

Can Oil Stocks Catch Up?
Despite the rapid rise in oil prices, oil stocks as a group have been lagging its performance so far this year.

The Select Sector Energy SPDR (NYSEArca: XLE) is ahead by just 10.48% year-to-date, compared to around a 72 percent increase in the price of oil over the same time period. XLE contains 40 stocks which represent the energy sector of the S&P 500. Exxon Mobil, Chevron, and ConocoPhillips are among the fund's top holdings.

Other ETFs tracking the energy sector like the SPDRS S&P Oil Gas Exploration (NYSEArca: XOP) and Oil Gas Equipment (NYSEArca: XES) are doing much better.  So far this year, XOP is ahead by 21.22% percent and XES by 43.87%. Even with the sizzling performance of oil ETFs concentrated in small baskets of oil stocks, crude’s recent performance has beaten those returns.

Attractive Valuations
Regardless of their lagging performance, some financial professionals remain bullish on oil and energy stocks. AltaVista Independent Research, a New York, NY-based ETF analyst says “A long-term case for XLE can still be made, given is low price-to-cash flow (P/CF) multiples.” The firm gives XLE a P/CF of 8.0, which is among the lowest of the nine S&P 500 industry sectors.

An ongoing concern for oil producers will be the unsettling threat of supply disruptions. Many top oil producers are faced with geo-political problems in oil producing regions such as the Middle East, Nigeria, and Venezuela. These problems have hampered both exploration and production.

Then too, there’s the problem of government control. Instead of letting companies easily export oil, some countries are nationalizing their oil industries and making it more difficult for oil companies to profit.

Oil Stocks or Oil?
Investors facing the choice of investing in oil itself or in oil stocks may wonder what to do. The closest thing to investing directly in oil is to buy futures contracts or to own an oil field.

Other alternatives, like investing in oil ETFs (NYSEArca: USO) aren’t attractive. USO, for example, has done a poor job of tracking its underlying benchmark (West Texas Intermediate light, sweet crude oil) because of a technical issue known as “contango.” Whenever the spot price of oil differs from forward futures as it often does, the possibility of tracking error is created. Even though USO has $2.79 billion in assets, investors aren’t getting crude oil’s actual performance. For the year, USO is up just over 15% whereas crude oil has soared more than 70%.

One of the advantages of investing in oil or energy stocks is the potential for earnings and dividend growth. Currently, XLE carries a 12-month yield of 1.8%. More diversified energy stock funds like the Vanguard Energy ETF (NYSEArca: VDE) carry a similar yield, but with less concentrated market exposure. Unlike energy stocks, the biggest disadvantage of investing in physical oil is that it pays no dividends or earnings.

In the meantime, oil’s run has yet to run out of gas.

*Performance figures through market close of June 9th, 2009

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