The Commodity Investor: 2 ETFs For Falling Gas Prices

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Includes: DUG, SCO
by: Hard Assets Investor

By Amine Bouchentouf

The message from last week's emergency-session meeting in Vienna of the Organization of Petroleum Exporting Countries was unequivocal: We are ready to live in a world of lower-priced oil.

The decision within OPEC was not unanimous, but it was indisputable. OPEC is divided into three categories: the Saudis, the low-price producers, and everyone else.

The Saudis hold a special place within the organization and are viewed as "first among equals;" this is for several reasons.

First, Saudi Arabia is one of the founders of OPEC; second, it is the group's most influential member in terms of production (Saudi is responsible for 33 percent of the cartel's output, making it by far the biggest producer); third, the country also has the biggest "spare capacity," meaning it can quickly ramp up or bring down total numbers of barrels produced on a daily basis; fourth, it holds the biggest reserves; and finally, it has significant influence over the biggest-consuming countries, such as the United States and China.

Discord Within OPEC

All in all, no other country dominates OPEC as does Saudi Arabia. OPEC is made up of 12 different countries, with each country having its own level of production, quality of crude and commercial and geopolitical interests to protect. During the November 2014 session, we saw a tremendous amount of discord among and between member countries, and for very good reason.

For the first time in almost five years, and for only the second time in almost 15 years, oil prices have been in free fall. Brent crude has been trading in the $100 per barrel range for most of the year. Now, it is down more than 30 percent, with no end in sight. A large supply glut has meant that customers have been asking for lower and lower prices for each barrel purchased. And producers must oblige because the supply is plentiful.

In OPEC's official statement, the organization made reference to "marginal producers." While not identified by name, the market knows exactly who these "marginal producers" are: North American shale producers. While each member within OPEC clearly recognizes the threat of American shale, each member had different suggestions for how to deal with this threat.

'Sweat Out' Shale Drillers

The Saudis and the Gulf countries suggest letting the shale producers get "sweat out" by lower prices. Many of the shale projects are only viable in a high-priced environment, because operational costs per barrel can reach as high as $80. If prices remain low, then these projects will become uneconomical, and this supply will be taken off the market through vicious competitive forces. If they don't make money, you need to shut them down.

The other group within OPEC was pushing for a supply cut in order to maintain higher prices. Countries including Venezuela, Nigeria, Ecuador, Angola and Iran were pushing heavily for decreased production from the cartel. The Saudis and Gulf countries ultimately prevailed, and thus OPEC has officially declared war on American shale.

The Trading Strategy

While there was plenty of disagreement among cartel members internally, the public decision is unequivocal: OPEC is willing and able to wage a price war against marginal producers in order to drive newcomers out of the marketplace. OPEC has wagered that its members, all sovereign states, have enough capital and resources saved up that they can survive $60 or even $50 oil.

If you're a commercial producer in North Dakota with investors, long-term debt, large capex programs, high employee overhead, unescapable federal taxes and stringent commercial obligations to honor, you might not be able to compete against a sovereign government with large cash cushions and a long-term commercial horizon. OPEC is betting that it can survive lower prices, which will drive the "marginal producers" out of the market.

Whatever ends up happening with shale producers, it is clear the market will have plenty of supply going forward. This means prices will remain volatile and in a downward-trending direction.

In this environment, The Commodity Investor recommends taking a look at ETFs that inversely track the price of oil and oil stocks; this means that when oil and oil stocks go down, the ETF will increase in value.

The ProShares Ultra Short Bloomberg Crude Oil ETF (NYSEARCA:SCO) offers exposure to double the inverse (-2x) performance of the Bloomberg WTI Crude Oil Index. The Bloomberg WTI index tracks the price of crude oil, as measured by West Texas Intermediate (WTI), which is the benchmark at the heart of the North American shale play.

SCO allows you to bet and profit on falling WTI prices; it also uses double leverage, meaning if WTI prices go down 5 percent, SCO will increase by 10 percent. In this falling price environment, SCO is already up 65 percent for the year; in fact, it's up 40 percent in the last three months alone.

While SCO can offer juicy returns, make sure to watch this ETF like a hawk, because it's volatile, thinly traded and the market can move on you quickly. Vigilance is the name of the game if you want to handsomely profit with SCO.

If you want to be against oil companies and their stocks, then you should opt for the ProShares UltraShort Oil & Gas ETF (NYSEARCA:DUG). DUG offers exposure to double the inverse (-2x) performance of the Dow Jones U.S. Oil & Gas Index. The index is a basket of leading exploration, production and services companies in the U.S., and includes holdings such as Exxon Mobil (NYSE:XOM), Chevron (NYSE:CVX), Halliburton (NYSE:HAL) and Occidental Petroleum (NYSE:OXY).

SCO vs. DUG

In an environment of falling oil prices, DUG offers you the capability to effectively "short" a basket of the leading energy companies. Right after OPEC made the decision not to cut production, DUG jumped 13 percent the same day. Over the last six months, DUG has increased more than 30 percent. Again, just like SCO, you need to watch this ETF like a hawk; this is not a "buy and hold" product-you need to actively monitor it, especially because of the leverage it uses.

It is clear that we have entered a brave new world in the energy industrial complex. The time of high prices is coming to an end, and you need the right tools to be able to profit. The two ETFs I presented above offer you the ability to profit when prices are volatile and going down.

Disclosure: The author doesn't have any positions in the stocks mentioned.