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How to profit if crude collapses

Not everyone believes in the supply-and-demand story that is fuelling oil prices these days.

Call them sourpusses, particularly if they've missed out on the stunning rise in energy stocks that has enriched others over the past several years. But they have a point: Since every surging asset in recent decades - from the Japanese stock market in the 1980s, to technology stocks in the 1990s, to U.S. real estate this decade - has created bubble-like prices that have subsequently popped, why should oil be any different?

Bloomberg News, in conjunction with Bespoke Investment Group, noted this week that the rise of crude oil prices has now exceeded the gains posted by the Nasdaq composite index during its glory years at the end of the last decade. Okay, this is an admittedly flimsy comparison - tech stocks generally had no earnings, while oil is generating billions of dollars in profits for energy producers today - but one that nonetheless gets you wondering if we're in for trouble.

A lot of investors have been doing more than just wondering: The ProShares UltraShort oil and gas exchange-traded fund (DUG/American Stock Exchange) has seen its average daily volume grow tenfold over the past few months to about 20 million units a day.

While more timid investors might avoid high-flying energy stocks altogether, these intrepid souls aim for a bigger bang. The UltraShort ETF, which resembles a mutual fund but trades on a stock exchange, tracks the Dow Jones U.S. oil and gas index of 86 stocks, including Exxon Mobil Corp. and Chevron Corp., but with a twist: When the index falls, the ETF rises twice as much.

That's right, if the price of crude oil takes a 10 per cent tumble and the share prices of U.S. oil and gas producers tumble by the same amount, then the ETF will rise 20 per cent.

In other words, you don't have to bet that oil is headed back to $10 (U.S.) a barrel, where it was 10 years ago; a modest decline to $100 a barrel, a 25 per cent dip from today's price, would give you a 50 per cent return on your investment if oil and gas stocks declined by the same amount.

For that scenario to work out, the world doesn't have to switch to electric cars and the Chinese economy doesn't have to fall into a deep depression. A rebound in the U.S. dollar might do it. So would a slight rise in energy conservation, as consumers recoil from the rising cost.

There is a risk here, of course: Just as the UltraShort ETF will give you an inflated return if energy stocks fall, it will also give you an inflated loss if energy stocks continue to rise. The unit price of the ETF, after all, has fallen 20 per cent this year as oil goes up and up.

For brave investors, though, that makes the potential reward just too great to pass up any longer.

See David Berman's Market Blog at ReportonBusiness.com

© 2007 The Globe and Mail. All rights reserved.

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