In recent years, investors increasingly use exchange-traded funds (ETFs) on the short end of their portfolio. Shorting these funds provides an easy way to hedge a portfolio managers’ position in individual stocks.

Yet some ETFs with high short interest are simply the target of speculators that are anticipating a big decline for an industry or asset class. When this happens, the short interest can grow to alarming levels.

For individual investors that are able to wait out near-term bears and focus on the long-term, it can mean a strong upside when sentiment turns.

The Market Loves To Hate Oil
As you’d expect, energy-related ETFs are an especially popular target for short sellers these days. In fact, almost every share held in long accounts for the SPDR S&P Oil & Gas Explorers ETF (NYSE: XOP) is also currently borrowed for short seller accounts.  

The latest headache for oil prices and oil stocks: fears are growing that U.S. oil storage tanks could reach capacity in April. While Petroleum Administration for Defense District (PADD 1) storage is near capacity at around 85%, total storage is only at 60% capacity.

The PADD regions were created during WWII to help with gasoline rationing but have become an important way to analyze supply and movement of energy products across the country. While PADD 1 is the largest energy user, PADD 3 is an important storage and refining region. 

To be sure, the high short interest in the fund does not necessarily mean a short squeeze is imminent (as might be the case with an individual company stock). ETF shares can be created or redeemed at will, but it does show the extreme pessimism in the sector.

Against this massive negativity, there are good reasons that fundamentals could change in the second half of this year.

The World Will Always Need E&P
Energy producers are trying to correct the current oversupply condition. Rig counts have fallen by more than half since October and are at the lowest level in four years.

Drillers have mothballed the least productive rigs, which means total output has yet to reverse course. Production growth, however, is slowing, according to the U.S. Energy Information Administration. Output from Eagle Ford and Bakken shale regions is expected to decline in coming months.

#-ad_banner-#This could happen just as refineries return from seasonal maintenance and gear up for summer driving demand. Rising economic activity points to more gasoline and diesel consumed this summer than in years past.

Slowing production growth and increasing refinery demand could support prices enough to put a bottom in the market.

The Organization of the Petroleum Exporting Countries, commonly referred to as OPEC, is another major factor.  

Even as Saudi Arabia and other members publicly disavow near-term production cuts, that sentiment could soon change. Nigeria’s oil minister and OPEC President Diezani Alison-Madueke told the Financial Times recently that talks are being conducted with member countries and an emergency meeting could be called if prices slip any further.

Beyond the potential for market fundamentals to rebound, oil prices could find support if the dollar stops rallying. Oil is priced in dollars, and the decline in oil prices has mirrored the rise in the dollar since last summer.

Although the global economic instability has given support to the dollar, stabilization in Europe and Asia could help the dollar — and oil — reverse course.

Against the massive pessimism on shares of the E&P ETF, investors might want to play contrarian to benefit from near-term and long-term potential. While individual companies may still face challenges, the E&P fund offers diversification across 80 companies in the space. There will always be a need for oil & gas explorers and the sector will eventually rebound with prices.

Any change in sentiment or supply fundamentals could send the fund back up to $60 in the second half of the year. Risk-averse investors can sell near-dated call options against a position to hedge their downside risk.

Risks To Consider: Production at U.S. fields is still growing and there is sure to be more volatility in energy names for at least a few months. Also, calling a bottom in oil is a difficult task, which makes an investment in this sector not for the faint of heart.

Action To Take –> Several factors could lead to a bottom in oil prices and even a rebound by the second half of the year. Take advantage of the extreme pessimism for oil and gas explorers to add a position in the diversified ETF.

If oil, natural resources or commodities are what interests you, look no further than StreetAuthority’s Scarcity & Real Wealth. Our resident natural resources expert Dave Forest has more than a decade’s experience as a trained geologist and analyst. His industry insight allows him to read the markets and provide the most timely, potentially lucrative advice for everything from oil and gold to molybdenum. Most recently, Dave has been talking about a rally in gold prices. To gain access to Dave’s latest research, click here.