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Bet Against an Oil Rebound with Inverse Oil ETFs

Oil pump

If oil prices fall further, several exchange-traded products could deliver stellar returns.

When oil prices plunged late in 2014, many expected that the decline would be temporary. But more and more experts are becoming convinced that low oil prices are here to stay, with some arguing that prices have much further to fall before bottoming out.

Though a few traders generated meaningful profits from oil’s recent plunge, most weren’t expecting the move lower. Betting against commodity prices is always a risky proposition. The volatile and unpredictable nature of this asset class, combined with the sophistication of the tools required, makes such a strategy inappropriate for most investors. But for those looking to implement a tactical short position on crude oil, there are a handful of exchange-traded products that make the execution of this trade relatively simple.

Below are profiles of four exchange-traded products that should increase in value if oil prices remain depressed.

United States Short Oil Fund (DNO)

As the name suggests, DNO offers short exposure to oil. Specifically, DNO holds a portfolio of futures contracts linked to West Texas Intermediate (WTI) light, sweet crude oil delivered to Cushing, Oklahoma. DNO will generally hold near month or second month futures contracts, which tend to exhibit near perfect correlations with spot oil prices over short holding periods.

While DNO is a great short-term proxy for oil prices, this relationship may break down when this fund is held for an extended period of time — for multiple reasons. Firstly, the “roll” process associated with a futures-based investment strategy can either enhance or erode returns depending on the state of the market. Each monthly roll that investors endure can lead to further divergence.

Secondly, DNO seeks to achieve its objective on a daily basis only. In order to accomplish this, exposure is reset at the end of each trading session. When oil prices oscillate back and forth between losing and winning sessions, the oscillation can have an impact on performance.

DB Double Short Oil ETN (DTO)

DTO is generally similar to DNO, in that it offers exposure to a futures-based bet against oil prices. However, there are a number of key differences. Most notably, whereas DNO offers daily inverse exposure to oil prices, this product strives to deliver 2x leveraged returns over the period of a month.

The use of leverage means that DTO will exhibit greater volatility in both directions. As shown above, that can lead to stellar returns when oil prices are falling as they did in the final quarter of 2015.

Because DTO seeks to achieve its results over a monthly time period, the effective leverage realized by investors may be greater or less than 2x, depending on when during the month they establish a position.

ProShares Short Oil & Gas (DDG)

The two products highlighted above offer direct exposure to crude oil futures, which results in a strategy that is nearly certain to deliver positive returns when oil prices drop. DDG takes another approach to betting against oil prices, effectively shorting several stocks that engage in the exploration and production of energy commodities.

Because the profits of oil companies tend to rise and fall with the cost of oil, these stocks generally exhibit a strong — but far from perfect — correlation to futures prices.

DDG effectively offers a way to sell short a basket of Big Oil stocks, including ExxonMobil (XOM) and Chevron (CVX).

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Similar to DNO, this fund rebalances its exposure on a daily basis. As a result, the direction and timing of movements in these stocks will impact the return of DDG for investors planning to hold it for longer than a single trading session.

ETRACS 1x Monthly Short Alerian MLP Infrastructure ETN (MLPS)

This product offers exposure to a generally similar strategy of DDG: betting against energy stocks. There are, however, several key differences. Firstly, MLPS is an ETN just like DTO, which means that investors are exposed to some credit risk (i.e., the risk that UBS goes bankrupt) but will have reduced tracking error.

Secondly, MLPS offers short exposure to a basket of master limited partnerships (MLPs) that are typically engaged in the transport and storage of oil as opposed to its discovery and production. Most MLPs operate pipelines that move energy commodities across North America, collecting a fee in exchange for this service. So while these companies operate in the energy industry, their revenue is not quite as sensitive to changes as spot prices as those of exploration and production companies.

The index to which MLPS is linked generally contains smaller companies with which many investors may not be quite as familiar:

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Betting against oil prices is a risky strategy; if a strong global economy pushes energy prices higher, all of the products highlighted above could rack up big losses in a short period of time. But if prices do indeed have further to fall, these could provide a nice short-term boost to portfolios.

About the Author: Michael Johnston

Michael Johnston is the Senior Analyst for ETF Reference, and also serves as the COO of parent company Poseidon Financial. His investment expertise has been featured in The Wall Street Journal, Barron’s, and USA Today, among other publications. He resides in Chicago.