Buy oil stocks now. Really

Prices are way down. But could food, energy, and metals still be part of a well-balanced portfolio?

(Money Magazine) -- It was only a year ago that commodity investments were all the rage. Oil prices were on their way up to $145 a barrel, from as little as $50 in 2007. With red-hot numbers like that, the financial services industry cranked up the marketing machine. Advisers touted commodities as an essential new asset class, right up there with stocks and bonds. New exchange-traded products let you track the price of oil and other commodities. In the first six months of 2008 a record $2.7 billion flowed into commodity-based funds, according to Morningstar.

You know what happened next. As the global economy slumped, demand stalled. Since last July, the Dow JonesAIG commodity index has fallen 56%.

After such a free fall, two obvious questions come to mind. First, was all the hype about commodity investments just a sucker play? Or is it possible that, with prices down so far, there are bargains to be had?

In fact, a case can be made for commodity-based investments now. But just as important, you should know you really don't have to go there. Chances are, you have exposure to commodity prices in your portfolio already. For those with the stomach for a roller coaster ride, though, an investment of 5% or so of assets in a commodity-based mutual fund could give your portfolio extra pop.

What's more, because commodities don't usually move in sync with stocks and bonds - the past few months notwithstanding - they are good diversifiers. They may lower your overall portfolio risk in the long run.

Commodities are simply the basic ingredients of modern life, from oil and industrial metals to livestock and coffee beans. They often do well when the economy is running hot, and they can give you some protection against a spike in inflation. (After all, you'll own some of the stuff that's getting more expensive.)

Hang on. A hot economy? Inflation? We're in a global recession, and the big concern of many policymakers right now is deflation. But that's the whole point. "The time to hedge against inflation is when people aren't concerned about it - and that's right now," says Chris Cordaro, a financial adviser in Morristown, N.J. And there is reason to think that when the price trend reverses, it will be in a big way.

For one thing, just as demand is falling, supply may be about to get tighter, especially in energy commodities. Oil-producing countries have recently announced massive production cuts. "In three to five years' time, I would not be surprised to see oil prices at $100 to $150 a barrel, or even higher," says FPA Capital fund manager Robert Rodriguez.

It's not just oil that stands to benefit from short supply. The credit crisis has meant that producers of everything from zinc to lead to soybeans have stopped investing in new production. That bodes well for commodity prices when the economy starts to recover.

Finally, let's assume that the Federal Reserve's and the government's efforts to stop deflation actually work. It's quite possible they'll overshoot. "If the economy catches gear, I'm afraid we could have a major inflation problem in the years ahead," says Brian Wesbury, chief economist at First Trust Advisors.

Now, taking advantage of an opportunity in commodities isn't quite the same as jumping into, say, small-cap stocks, where you can just go to Vanguard or Fidelity and buy an index fund. As you'll see, with commodities there are a lot more moving parts.

The simplest way to get in on commodities is to buy shares in the companies that take the stuff out of the ground, sell it, or process it. Those firms will often benefit from rising prices for the commodities themselves. In the 12 months leading up to the $145 per-barrel peak, Exxon Mobil stock outperformed the broader S&P 500 index by 20 percentage points. And, of course, it followed oil prices down too.

Why it's complicated: That said, you can't always count on a stock in a commodity-related business to move in the same direction as prices. The demand for stocks in general could influence your returns as much as the commodity price. And many firms diversify their business so that they aren't so sensitive to price changes. For example, oil firms may own gas stations, which can benefit from cheap crude.

The best strategy: If you own a diversified stock fund, you have a lot of indirect exposure to commodities, especially in energy. (An S&P 500 index fund is about 13% energy stocks.) So add around the edges. Your best bets are a pair of low-cost Money 70 picks. T. Rowe Price New Era (PRNEX) is an actively managed fund that may shift among energy, mining, and other industries depending on where manager Charles Ober sees opportunities. The iShares S&P Natural Resources Sector Index Fund (IGE) is an exchange-traded fund that simply holds an index of commodity firms.

The more direct way to invest in commodities is through the futures market. Instead of buying, say, a barrel of oil - where would you put it? - you buy a contract promising to buy it for a specified amount sometime in the future. If prices rise above your contract price, you win. This involves margin accounts, frequent trading, and wild price swings. You could have your entire investment wiped out quickly. It's not a good market for individual investors.

In recent years, however, new funds have opened up that allow you to easily track broad indexes based on futures prices. At the same time, new research has suggested that a buy-and-hold investment in such an index could provide you with impressive long-term returns, in addition to better diversification.

Why it's complicated: The diversification argument makes sense. But the jury is very much out on whether commodities can make you much money over the very long run. Only some of the return from futures comes from rising prices for the raw material. Another big factor is called roll return - the gain that traders can pocket if the price of the expiring contract they're selling is more than the new contract they're buying. Roll returns have been good in the past, but may be less attractive in the future as more investors seek to own commodities contracts, notes a report from AllianceBernstein.

Your best strategy: Avoid the "exchange-traded notes" that track futures. They look a lot like exchange-traded funds, but they are backed only by the credit of the issuer. That's not a risk you need these days. The better play: Harbor Commodity Real Return Strategy (HACMX), which uses financial contracts to track the Dow JonesAIG commodity futures index. It too is a complex investment, involving derivatives, leverage, and inflation-protected bonds. If you prefer to just keep things simple - hey, life is short - stick to the stocks.