Less than three months ago, I was surprised to see one of my tennis buddies drive up in a Toyota Prius. Don't get me wrong, there is nothing wrong with a Prius, it's just that I was used to seeing him in his black Range Rover with 22 inch rims. As it turns out, he traded his beautiful Range Rover for a not so beautiful but fuel efficient Prius.

He wasn’t the only one; the lot at CarMax was filled with low-MPG vehicles while GMC (NYSE: GM), Ford NYSE: F) and Chrysler nearly phased out their SUVs and focused on commercials that dubbed any car with less than 15 MPGs as fuel efficient. Today, gasoline (AMEX: UGA) is cheaper than it was three years ago. I wonder if he wants his Range Rover back.

Curiously, big oil posted another round of record profits. Exxon Mobil (NYSE: XOM) broke its previous record, when it announced a Q3 profit of $14.83 billion. Houston based Conoco Phillips (NYSE: COP) reported a record $5.18 billion Q3 profit.

Lower gas prices - higher profits?

Earlier this year, companies struggled to pass on the rapidly rising cost of crude oil to consumers. This sounds strange as gasoline at over $4 / gallon nearly suffocated the economy, but as the price of crude oil more than doubled, the price of gasoline increased by “only” about 35%.

The opposite was true in the third quarter when pump prices fell more slowly than crude prices and boosted the profit margins of big, turn-key oil companies that pump oil, refine it and sell gasoline to the public.

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Nonetheless, melting crude oil prices drove down baskets of energy stocks like the Energy Select Sector SPDRs (AMEX: XLE)  harder and faster than the S&P 500 (AMEX: SPY). It’s not all bad news though for big oil. Commodity prices fell just as much as oil prices, resulting in lower costs for building platforms and extracting oil.

High oil prices equal higher overhead costs

Red-hot crude had led to unprecedented cost inflation and made it harder for oil companies to land long-term deals to get untapped reserves with oil rich countries. Oil specific ETFs such as the SPDRs S&P Oil & Gas Exploration & Production ETF (AMEX: XOP) and the iShares Dow Jones Oil Equipment & Services ETF (NYSEarca: IEZ) benefitted from higher extraction costs earlier in the year but started falling behind as oil prices plummeted.

Big oil doesn't need $150 / barrel oil to churn profits but was happy to book the extra revenue anyway. Oil companies can remain profitable as long as oil prices don’t drop below $50 or $60 / barrel. Crude oil along with oil's commodity ETF (AMEX: USO) already dropped as low as $60 / barrel and execs were starting to sweat.

How low is too low?

It was time for oil’s Godfather to step up to the plate and curb the bleeding. OPEC (Organization of Petroleum Exporting Countries) ordered its member nations to cut oil production by 1.5 million barrels a day (the U.S. consumes roughly 21 million barrels a day).

This move didn't make a big dent. Perhaps because OPEC now controls only 40% of the world oil market, down from 73% in 1973. Oil prices did spike briefly before retreating after Saudi Arabia (not an OPEC member) agreed to cut production by an estimated 900,000 barrels per day. Geeks for conspiracies believe that oil will go up again once a President is elected and the political motivation to keep oil down is gone.

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July oil prices - another bubble?

The key question is whether the spike in oil was a bubble similar to technology (Nasdaq: QQQQ) and financials (AMEX: XLF) or if it was a foreshadowing of things (high oil demand) to come. It takes decades to digest the enormous extremes present during a bubble but it may not take as long for oil to bounce back.

We do know that the Index Of U.S. Factory Activity, a barometer for future oil demand, sank to its lowest reading in 26 years. We also know that the Baltic Dry Index, an index which measures the demand for shipping capacity through dry bulk shipping rates, is down more than 90% since May.

The Claymore/Delta Global Shipping Index ETF (NYSEarca: SEA) fittlingly reflects this contraction with its 45% loss since its inception on August 22nd. Even lower oil prices might be on the horizon, but there is a flip side to the coin.

When major newspapers like Barron’s and the Wall Street Journal ran cover stories about the scarcity of oil and forecasted $200 / barrel oil, we knew it was time to limit exposure to the black gold. Chances are, when the same outlets start talking about financial troubles of big oil companies and $50 / barrel oil, it is time to get back into oil.

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A weak dollar and the perception of skyrocketing demand by emerging countries like China and India created the perfect storm for oil prices. As global economies continue to struggle, a strong dollar should put a lid on oil prices for the foreseeable future. This time around you might get better leverage (up-side exposure) will oil equity ETFs than ETFs directly linked to the price of oil. Well managed companies tend to bring better returns than the commodity itself.

Not all energy ETFs are created equal



The iShares DJ US Energy ETF (NYSEarca: IYE), Vanguard Energy ETF (NYSEarca: VDE), PowerShares Dynamic Energy (NYSEarca: PXI), PowerShares FTSE RAFI Energy (Nasdaq: PRFE), First Trust Energy Alpha DEX (AMEX: FXN) and Rydex Equal Weight Energy ETF (NYSEarca: RYE) provide broad exposure to energy.

Not all ETFs are created equal. The security selection and security weighting methodologies vary from one ETF to the next. Some weight component stocks by market capitalization others weigh them according to fundamental metrics while Rydex weights them equally.

Just as a four cylinder engine performs different than an eight cylinder engine, one ETF performs different compared to others. Obviously, when it comes to ETFs, superior performance is what everyone’s after. Investing with an inferior ETF would be like running a NASCAR race in a Prius?

For a detailed analysis of market cap weighted vs. quantitatively weighted ETFs, refer to the October edition of the ETF Profit Strategy Newsletter.