By Julian Murdoch

We covered the year in ETFs (so far) last week  with unsurprising results: eight of the top 10 ETFs were in energy, and the other two were broad commodities indexes with big fat oil exposure. The logic here is pretty simple. Check out the basket:

Price Changes: January 1 - June 30, 2008

CRUDE OIL

Let's start with the obvious: Oil.

Charts can be a little misleading at first glance, because how you scale the Y-axis makes all the difference in the world. The first curve doesn't look that steep, but the truth is that crude oil rose 40% between January 2 and June 30 of this year. Here's how, oh, let's say, USA Today would show the same chart:

The year started with a brief foray to a high of $100 a barrel - brief because it seemed like the market just wanted to show everyone that oil could, in fact, break the magical $100/barrel barrier, as opposed to any real fundamental reason for that price.

The next few weeks proved that the market was not yet ready to support oil at that level. Ahh, the halcyon days of winter! It wasn't until late February that oil broke the $100 barrier again - this time spending some time getting to know the number before moving on to higher highs. A new high of $120 was achieved in April, then $130 in May and finally $140 was hit and surpassed at the end of June. The high price is having some effect - demand for the first half of 2008 was down 3%, which is the largest drop in 17 years.

Why the meteoric rise in these few short months? The reasons most commonly cited in the media (which we'll include ourselves in) are supply constraints (give us more oil, OPEC!); unrest in the Middle East (quarrels between the U.S., Iran, Iraq and Israel - in various combos); other "minor" supply interruptions (strikes and militant attacks in Nigeria); and the role of speculators.

Just a few of the headlines:

In April, the IEA reported that Russian oil production had declined for the first time in 10 years. The decline was only 1% for the first quarter of 2008, but it was significant because Russia has historically been a source of new production. Things don't seem to be getting better (at least according to this recent report) and Russia may be out of the new-oil club for the first time in over a decade. Russia's woes are just symptomatic of what's happening almost everywhere: Aging oil fields and slow development of new projects.

In May, the IEA warned that it would be revising its oil-supply forecast down. This was a blow, because the IEA has just been getting into the business of really digging into supply. This just created further evidence that yes, Virginia, there's a bit of an oil shortage looming.

Also in May, we had a tiny and truly insignificant event in the U.S., which was the U.S. Congress' vote to suspend filling the strategic oil reserve (signed by the president May 19). File under "lots of headlines, zero impact.

WHITHER OPEC?

With 2008 being a story of supply panic (in the face of a continued belief in the insatiable demand from China), where the heck was OPEC?

On one hand, this year has been one of change for OPEC - at least in terms of membership. In January, Ecuador rejoined the organization (it was last a member in 1992), and in May, Indonesia left the organization because it had switched from a net exporter to a net importer of crude.

But on the other hand, they have not officially changed their production quotas. Meetings in February and March resulted in decisions to leave production quotas where they were. OPEC has maintained that the world is well-supplied with crude - no matter the price or how loud the pleas from the IEA or the U.S. But despite the quota lock, there have been some marginal increases in production. In May, Saudi Arabia increased its production by 300,000 barrels a day (b/d) and planned for further increases of 200,000 b/d for July, as well as being open to the possibility of further increases, if needed. The truth is that OPEC seemed to be pumping as much as it can. In fact, an article by Platts in June quoted an OPEC official suggested as much:

"A senior OPEC delegate said Monday that OPEC ceilings and quotas had become largely irrelevant and that OPEC had a 'tacit' understanding that those members capable of boosting crude production should supply as much oil as world oil markets needed."

Of course, OPEC continues to insist that there is no supply shortage of crude, and the escalating prices are due to the dollar's weakness and greedy speculators.

Also on the subject of OPEC, some lawyers may be discovering a new revenue stream. Under pressure by the American people to "do something" about high gasoline prices, on May 23, the U.S. House of Representatives passed legislation to clear the way to sue OPEC - a viable option or a good sound bite? It's an election year. You decide.

But throughout all of this, the underlying theme was one of inflation. As a commodity priced in dollars, it's axiomatic that a falling dollar means a higher dollar price for oil. And this, the background hum of oil as an inflation hedge, has been in the atmosphere for months, and with it, the specter of evil speculators, using the oil markets as (heaven forefend!) a place to stick capital. Last time we checked, that was the point of using markets to make resource allocation decisions.

DISTILLATES: GASOLINE, DIESEL, HEATING OIL

Of course, very few American consumers buy crude - instead, we buy distillates: Gas, diesel and heating oil, for the most part.

Remember the good ole days of two-dollar-a-gallon gas? Me neither. RBOB gasoline on NYMEX went from $2.55 a gallon to $3.49 between January 2 and June 30 - an increase of 37%. Not quite as high an increase as crude, but still breathtaking. The pain at the pump has had a big impact on consumers' wallets - and their driving habits. At a time when demand usually goes up, June saw gasoline demand drop by 3.2% - bringing the first half of the year demand total down 1.7%. Whether this reduction in demand is meaningful or lasting remains to be seen

NATURAL GAS: WHAT SEASONALITY?

Natural gas rose over 69% percent in the first half of 2008 in a fairly steady climb. That's the headline in and of itself. Here's how Natural Gas usually performs: Prices rise as the cold weather comes in the fall, and as the weather warms in spring, demand for natural gas for home heating decreases and prices drop. As the hotter summer months arrive, natural gas experiences a second, though not as steep price rise, as demand for electricity increases. 2008 looks essentially nothing like that. Prices started the year around $8 per mmBtu and continued to climb up to $13 per mmBtu with comparatively little volatility along the way. We covered this just a few weeks ago, and it's still troubling.

One of the more unusual news stories that came out in the first half of 2008 regarding natural gas is T. Boone Pickens' plan. His idea to use wind for electricity, and use the "freed-up" natural gas to fuel our cars is something that - if either possible or politically feasible - would actually impact the natural gas market. But for now, it's just so much gas, and years down the pipeline, at that.

COAL

The unsexy little rock saw its price rise over 140% during the first six months of the year. Why? Simply put, tight global supplies combined with high demand - Economics 101. Global supplies were tight this year because of two supply-side shocks: 1) China experienced severe winter storms that cut exports, and 2) power shortages in South Africa reduced production. With global supplies tight, more U.S. coal was exported, leading to higher prices.

The demand equation, not just in China, but everywhere, doesn't change fluidly. China's had to reopen its aging-and-dangerous small mines to keep up with demand. Here in the U.S., demand for coal is essentially tied to the demand for electricity - another factor which changes surprisingly little over short-term time periods. Despite all the talk about clean fuels, some folks are estimating that the U.S. electrical grid is going to become more reliant on coal than ever in the coming decades - from 48% to 54% over the next 20 years.

But that's 20 years. For the next six months, it will all be about supply. And in the case of coal, no news is probably good news.

ALTERNATIVE ENERGY

Pickens' throwaway lines on wind power are symptomatic of a media groundswell on alternative energy. But in terms of finding good, up-to-date statistics, and viable investment vehicles, alternative energy is the red-headed stepchild of the energy world.

Ethanol grabbed most of the headlines during these first six months, but mostly as the scapegoat for global food shortages. The reality is that ethanol is an agricultural story. How is the corn crop doing? What's the price per bushel? How badly are ethanol producers being squeezed? Ethanol prices have not kept up with gasoline prices, and if a plant can't make it work, it shuts down. Data from the end of March shows that capacity and production continue to grow, with 561,000 b/d of domestic ethanol produced in March - up from 384,000 b/d in March of 2007.

Wind power has also seen a growth in capacity. As of the end of March, the U.S. had an existing 18,302.68 megawatts (MW) of wind power installed - an increase of 8.8% from the end of 2007. (There were 16,818 MW of installed wind power at the end of 2007.) A further 5,736.3 MW were under construction at that time.

But the reality - from an investor's perspective - is that alternative energy is about venture capital and the fate of individual companies, not commodities. At least, it is until we get ourselves a BioWillie station up here in New England.

THE ROAD AHEAD

To paraphrase Donald Rumsfeld: We've got the known knowns, the known unknowns and the unknown unknowns.

The Unknown Unknowns

The biggest impact on oil in the next six months is essentially the question of the playground. How well is everyone going to play together? If tensions continue to rise between Iran, the U.S. and Israel, serious supply consequences - or the fear of them - would result. Conventional wisdom is that if things really deteriorated, oil simply can't get out of the gulf region easily due to Iran's strategic position (or rather, its possible stranglehold) on shipping lanes. That's not just an idea, it's an actual threat.

On the other side of Africa, Nigeria had numerous problems this year with labor disputes and militant attacks reducing production significantly in the beginning part of the year. While things seem relatively quiet now, there is no guarantee that these problems are over. But the situation in Nigeria is very far from stable. Speaking of instability, there's always Hugo Chavez, everyone's favorite Crazy Uncle, sitting just a thousand miles away in Venezuela. We're not sure what he's got in mind for the next six months, but we do know it will be wacky fun and never good. The most recent indication is that he's spending some of his oil-loot on billions of dollars of Russian military hardware, including submarines and attack helicopters.

And then there is demand. Predicting demand and consumption numbers can be like looking into a crystal ball. Gasoline consumers have a large role in the price of oil, even if they feel like they have none. If gasoline consumption continues to decrease, the price of oil will come down - eventually. It will take a long time for people's consumption patterns to change significantly, but with the increasing emphasis on alternative fuels, higher-fuel-efficiency cars and conservation will have an impact. And of course, the big demand unknown remains the developing economies of Asia. The story of 2008 has been one of a giant commodities vacuum originating at the port of Shanghai. How long this can continue - and at what prices - is perhaps the biggest unknown of all

THE KNOWN UNKNOWNS

OPEC's next scheduled ordinary meeting is September 9 in Vienna. Many (myself included) believe that at this point, OPEC members are essentially pumping at capacity, and thus it's an easy guess that there won't be any meaningful official increase in production quotas. The only way that production quotas would come down is if the price of crude falls precipitously.

There are two big events in November that will really impact the market, however.

First, there is the report due out from the IEA on the status of the world's top 400 oil fields. This won't be making headlines in the New York Post, but it could possibly be the most important piece of oil news we'll see for the rest of the year. It's the first survey report of its kind, looking at the health, depletion rates and supply of the world's oil fields. This report could (and hopefully will be) a brutally accurate assessment of how the world's oil infrastructure is actually doing, and by extension, determine if not the winner, the true favorite in the continuing Peak Oil debate.

Also in November, a little thing called the U.S. presidential election. While we don't know exactly who is going to win - we're pretty confident we can narrow it down to one of two. Whoever takes up residence in the White House come January 2009, is going to play a huge role in where energy markets are going to go. Foreign policy, energy policy, economic policy - these all influence the companies, nations and individuals that make up the energy market.

Here's a little recap of both candidate's energy plans from a previous article:

Both candidates pay lip service to alternative fuel sources, with Obama proposing directly funding research into all forms of clean fuel and McCain supporting tax credits to encourage the market to use low-carbon fuels like wind and solar. McCain does propose direct funding of clean coal technology research to the tune of $2 billon. On the question of drilling on the Outer Continental shelf and the Arctic National Wildlife Refuge, McCain supports lifting restrictions; Obama wants to keep the restrictions in place.

President Bush has already lifted the White House executive ban on offshore drilling - the one that his father, President George H. W. Bush, signed in 1990. President Bush also supports drilling in the ANWR. Chances are slim that our current president will be able to effect any major changes in these last few months of his term, but all bets are off after the election results are in. Not only are we electing a new president, we will also be possibly changing the makeup of the Congress that he has to deal with. (Thirty-five of 100 Senate seats are up for re-election - 23 Republicans and 12 Democrats. All 435 House seats are up this year. The Democrats currently hold majority in the House of Representatives, with 236 seats, the Republicans have 199 seats.)

Another big known unknown is whether seasonality may return to various markets as we progress through 2008.

Demand for gasoline usually drops off after the summer driving season, with people going back to their usual routines, having taken any road trips they had planned for the nice summer months. Since the numbers seem to show that Americans are already driving fewer miles and increasing their use of public transportation, that pattern is up for grabs. Conversely, natural gas demand usually starts to rise as cold weather hits, due to home heating demand and accompanying price increases. Since prices are high already, we may see them push even higher. Heating oil should begin to rise again as well. How high demand will go is a function of how cold a winter it is - and how expensive it is to turn the thermostat up a few degrees. The Weather Channel can help you there.

THE MAGIC 8-BALL

If it were fearless prediction time (and when isn't it?), I wouldn't be betting on a significant softening of energy prices across the board. The first six months of the year did nothing if not reiterate the primacy of crude in setting the bar for the world's energy markets, and with little hope of substantial pullbacks there, it's difficult to create a case for any of the others. The uncertainty of the second half is, if anything, greater than it was in the first half, which means higher volatility. The proverbial wild ride continues.