Curbing Enthusiasm For Oil Upside

Don't look now, but the United States Oil Fund LP (ETF) (NYSE:USO), which tracks front month West Texas Intermediate futures, is up 5 percent in the past month and investors have poured more than $1 billion into the fund in the third quarter.

Those statistics sound enticing, but investors might not want to get too excited about the prospects of an epic oil rebound. At least that is the view of some market observers.

But while the recent crude price movements have been extraordinary, I still believe that oil prices will, for the most part,remain range bound, withthe global benchmark Brenttrading between $50 and $65 and WTI trading at a modest discount. Though crude is currently a bit below the lower end of that range, oil prices should, for the most part, remain within that channel going forward, with a bias toward the lower end, said BlackRock Global Chief Investment Strategist Russ Koesterich in a recent note.

The mid-point of the range outlined by Koesterich is $57.50 per barrel, or 27 percent above where West Texas Intermediate closed on Tuesday. That would be a new bull market and then some for the benchmark U.S. oil contract, which assuming that move happens, would likely be good news for moribund equity-based energy ETFs such as the iShares U.S. Energy ETF (NYSE:IYE) and the iShares U.S. Oil & Gas Exploration & Production ETF (NYSE:IEO).

IYE and IEO enter Wednesday with year-to-date losses of 19.6 percent and 18.1 percent, respectively. Though nothing to shout about, IEO has been less bad than its more diverse counterpart IYE in part due to the former's larger exposure to refiners.

IEO allocates 27.2 percent of its weight to dedicated downstream and marketing companies and features three refiners among its top 10 holdings. That is nearly triple the refiners weight found in IYE. Phillips 66 (NYSE:PSX), a company Warren Buffett's Berkshire Hathaway Inc. (NYSE:BRK-A) recentlyamassed a massive stakein, is the only refiner found in IYE's top 10 roster. However, IEO's weight to Phillips 66 is more than double that of IYE's allocation to the stock.

Other issues need to be considered by investors before rushing into these or other oil ETFs.

What could cause oil prices to break out of the expected range? A major risk to the downside is that the slowdown in emerging markets infects developed markets, leading to a global recession. On the other hand, given the ongoing security issues in the Middle East, its still possible that a significant supply disruption (one measuring at least 2 million bpd) could push oil back to, or through, the upper end of its range. In the absence of either scenario, investors should expect continued range bound volatility, adds Koesterich.