Offset high prices at the pump by investing directly in crude or energy stocks. By David Landis, Contributing Editor July 31, 2008 The prospect of $200-a-barrel oil used to be unthinkable. But crude's price has already more than doubled in the past year, to $139 in mid June, so another 44% rise is hardly unimaginable. Goldman Sachs analyst Arjun Murti, who accurately forecast triple-digit prices several years ago, says oil will hit $200 a barrel within the next couple of years.Murti may be right again. Or oil may represent a classic bubble about to burst. Trying to determine short-term price swings is sheer speculation, although you can make a strong case that the long-term trend is up, primarily because of growing demand in emerging markets. Whatever the next short-term move, it pays to have exposure to oil in your portfolio. Oil stocks or investments that track the price of crude itself provide a double hedge. They help offset rising gasoline prices and other increases in your energy costs. And they can counter the damage done to your other stocks, which lately have shown increasing vulnerability to rising oil prices. Even though oil and other commodity investments can be volatile, they are tamer when combined in a portfolio with stocks and bonds because the risks of each type of investment balance one another to some degree. Stocks used to be the only avenue for the average individual to invest in energy. But that has changed in recent years with the introduction of exchange-traded funds (and their cousins, exchange-traded notes) that track commodities. Here is a look at some of the best ways to play rising energy prices, both for stock investors and for those who want to ride commodity prices. Advertisement Direct bets. When you buy an energy stock, you are betting not only on the price of oil, but also on the quality of the managers who run the company. By investing in oil itself, though, you cut company management out of the equation (for better or worse). The purest oil investment, short of storing barrels of crude in your garage, is United States Oil, an exchange-traded fund that tracks the price of West Texas Intermediate, the U.S. benchmark grade of crude. The ETF (symbol USO) returned 107% over the past year to June 9, closely mirroring the return of the futures contracts it buys. But U.S. Oil and other futures-based ETFs come with their own set of quirks. Futures prices sometimes lag the cash-market price (the price you often hear about on the news) because of a condition called contango. When the market is in contango, ETFs such as U.S. Oil must buy the next-month futures contract at a premium price and, when it expires, sell it at the lower cash-market price -- a losing proposition. Most of the time, oil-futures markets are not in contango. But when they are, a new fund, United States 12 Month Oil (USL), mitigates the problem by tracking the average price of 12 months' worth of futures contracts rather than the next-month contract. For that reason, we give a slight edge to this fund over U.S. Oil. Year-to-date to June 9, 12 Month Oil, which launched last December, returned 40%, compared with 36% for U.S. Oil. Advertisement Crude oil, of course, is just one of many energy products. You can find ETFs that track other types of energy, including United States Gasoline (UGA), United States Natural Gas (UNG) and United States Heating Oil (UHN). But prices of these commodities don't necessarily move in lock step with the price of crude oil, and it's hard to get the timing right, in any case. You would be better off simply buying the bunch through the iPath Dow Jones-AIG Energy Index Total Return Sub-Index ETN (JJE). A subset of the Dow Jones-AIG Commodity index, it tracks a collection of energy products, including crude oil, natural gas, heating oil and gasoline. Launched last fall, it has returned 52% year-to-date to June 9. The iPath fund is an exchange-traded note. Unlike an ETF, which buys the underlying futures contracts, an ETN is a bond that promises to pay a return identical to the futures (plus interest on cash collateral for the contracts). So while the ETF's returns can stray slightly from those of the underlying futures, the ETN's returns will always be spot on with the futures (plus interest and minus the ETN's expenses). ETNs are also taxed at a lower rate than ETFs. On the negative side, the ETN, as a bond, could fall in value if its issuer (in this case, Barclays Bank) runs into financial trouble. In addition, there are signs that Congress and the Internal Revenue Service may eliminate ETNs' tax advantage over ETFs. In general, we like ETFs better, although we don't mind recommending some ETNs when there's no ETF alternative. The stock route. Despite the possibility that management can mess up a good thing, it's prudent to own shares of energy companies, too. True, in a bull market, share prices may not climb as fast as commodity prices do -- particularly for the multinational behemoths that dominate the industry -- but the stocks are less volatile. And many energy stocks pay a dividend. In addition, stocks (and, for the moment, ETNs) get better tax treatment than futures-based ETFs do. Dividends and long-term gains are taxed at a 15% rate, while 60% of gains from futures-based ETFs are taxed at the lower, long-term rate and 40% are taxed at short-term rates, which can be as high as 35%. What's more, you have to pay taxes on your futures gains every year -- even if you don't sell your ETF shares. Advertisement For indexers, there's a rich selection of low-cost, stock-based energy ETFs. Our favorites are the Energy Select SPDR (XLE), which owns the 36 energy companies in Standard & Poor's 500-stock index, and iShares S&P Global Energy (IXC), which owns many of the same firms but adds foreign stocks, such as BP and Brazil's Petrobras. The funds perform similarly. The Energy SPDR returned an annualized 28% over the past three years and 30% over the past five to June 9, compared with 25% and 27% for the Global Energy fund. We like the SPDR's low annual expense ratio of 0.23%, but note that the portfolio is heavily concentrated in ExxonMobil, Chevron and ConocoPhillips (38% of the fund's holdings, combined). Global Energy's 0.48% expense ratio is less of a bargain, but the ETF provides a little more diversity. It owns shares of 74 companies, about half of them based outside the U.S. Several mutual funds are also worth considering. Vanguard Energy (VGENX) holds many of the global industry giants that the indexes own, but in much smaller concentrations. The fund also provides exposure to coal stocks, which are hard to find in the oil-and-gas-dominated indexes, as well as a smattering of utilities. It returned 33% over the past year and an annualized 34% over the past five years. T. Rowe Price New Era calls itself a natural-resources fund, so it can stray outside of the energy arena. For example, it owns Barrick Gold, a gold-mining firm, and mining-equipment makers, such as Joy Global. But longtime manager Charles Ober keeps most of its assets in energy and does a good job beating the energy indexes, with below-average volatility. The fund (PRNEX) gained 34% over the past year and an annualized 31% over five years. Advertisement For an off-the-beaten-path approach to energy investing, consider an alternative-energy fund. These funds invest in nascent technologies, such as solar energy and wind power, that should become more appealing as fossil-fuel prices and concerns about global warming rise. The year-old Market Vectors Global Alternative Energy ETF (GEX) tracks 30 of these companies, focusing on those that have the highest market value and trading volume. The fund gained 30% over the past year, but its returns are susceptible to big swings. Another way to play energy is with a closed-end fund, which issues a limited number of shares that trade like stocks on an exchange. BlackRock Global Energy and Resources Trust (BGR) is one of our favorites. It owns mostly midsize and large energy companies and currently has a big stake in coal stocks (see Great Stock Funds on Sale). In mid June, the fund traded at a 15% discount to the value of its assets. Investors can profit if the discount narrows or if the value of its assets rise. In the past year to June 2, the fund's assets returned 32%. If you prefer individual stocks, ExxonMobil (XOM) should be on your buy list. Size and resources make a big difference in the energy industry, and there isn't another nongovernmental energy firm that comes close to Exxon on either count. At $89, the shares recently traded at a reasonable ten times estimated 2008 earnings of $8.86 per share.