Hedging the Price of Oil

Oil prices have been steadily declining over the last couple of months and some are wondering how long this will last. The price of oil is around $67/barrel (1 barrel of oil approximately equals 42 US gallons or 159 liters) for December 2008 delivery, less than half of what we saw this past summer.

However, the prices of future deliveries have not fallen that low. The prices for December 2013 contracts (to take oil delivery 5 years from now) are about $90, which indicates that at least a few traders believe that the price of the oil will go back up at some point. Let’s analyze what is happening and see how we can take constructive action to protect us from a future rise in oil prices. We suggest two ETFs that might help you make constructive investment decisions based on this.

What is happening?

The summer's oil shock seem to have had an enormous impact on oil consumption. Consumers have found ways to reduce oil consumption - lesser driving, efficient vehicles, etc., and thus the world demand has fallen. US consumption fell over 10% to around 18 mbpd (million barrels per day), while OECD (the group of developed countries)  consumes 1 mbpd  less than at the start of year. Total world consumption is around 85 mbpd.

Oil is a highly inelastic commodity, both on the supply side and on the demand side. Consumers cannot immediately cut or increase oil consumption, and producers cannot immediately find newer fields or shut down existing fields with changes in prices. Given this nature of the commodity, prices are always a guessing game. 1% change in either the demand or the supply can substantially change the prices.

As seen in the second chart, world production will continue to increase over the next  two decades, and big questions remain on how far this will be consumed.

The future price of oil hinges a great deal on current recession. If China and India (both having a fraction of US per-capital consumption) continue to grow, then it is very likely the world will see the demand back up and prices moving again.

However if this recession prolongs and causes another 10-20% reduction in US oil consumption, then prices can collapse substantially and fall to 1990s levels (when oil was at $10/barrel).

How do we hedge the price of oil?

Given that we cannot easily predict the price of oil, and that a 1% increase in demand or drop in supply could bring oil back to triple digits, how do we hedge the risk? How do we protect ourselves from a further shock? The fundamental way to do so is to buy futures contracts (you can even buy 5 years from now). But, then the minimum contract size is 500 barrels (for mini futures – QM) and 1000 barrels (for CL). Given that a barrel is 42 gallons and an average American consumes less than 10 barrels a year, this will be too big for most of us. And, unless you have that much free cash lying around, you might be buying them in margin (you will pay a minimum of $10K per CL contract and get the rest $50K in margin) and if oil goes down you might be asked by the broker to pony up a lot of money. If you have questions, you can call up Southwest Airlines (LUV) and ask how they managed to screw things up. Unless you are a pro trader, we would suggest you not to take up futures markets.

A simpler way to hedge oil is to buy UGA and USO. USO and UGA are ETFs that track the prices of crude oil and gasoline respectively. These behave like index mutual funds; if oil goes up 20%, USO will go up 20%, and vice versa. Same thing with UGA, though with the underlying being gasoline. Unlike futures contracts, you cannot lose more than the initial money you put and risk management is fairly easy. Also, you could buy in units as low as $100. USO has a management expense of around 0.50% and tries to track West Texas Intermediate light, sweet crude oil (one of the popular standards for oil) and they try to use futures contracts to achieve this purpose. It trades now at the same level as November 2006, while oil prices have slightly moved up in the period. There is a bit of inefficiency in its tracking and this must be taken into account during long term planning.

Kindly do your own homework and understand the fact that oil prices are highly volatile. Be aware of all the risks posed by oil as a commodity and the specific risks of these two ETFs.

Read more:

1. "Changing Energy Usage Patterns"
   
2. USO - fund facts
3. UGA - fund facts
4. Historic oil prices
5. EIA’s Energy Outlook
6. Key energy statistics
7. "Supply Worries Persist in Oil Market, Just Not Now"
8. "How To Hedge Against Rising Gas and Oil Prices?"

Disclosure: No position in USO and UGA

Header image courtesy of Fabio

Comments

[Ferdinand E...:]

Interesting. I just finished explaining to a gentleman that there is no liquidity in the oil futures market for contracts with a maturity of more than 6 months, and often less, and now I read in the above that it is possible to buy futures for 5 years.

Somebody said that there is a fool born every minute, but I think that every second is more appropriate. Don't they teach people anything at all in those store-front universities on Wall Street or Rodeo Drive.

2008 Nov 05 09:28 AM

[Balaji Visw...:]

Buying such long term futures makes sense for a lot of companies even more than near term futures. Southwest used such long term futures to make good profits for a long time (till the previous quarter). If you are a big airline, you know you need oil for a many years to come and if you are big oil producer you know you will produce for a long time to come. Both these companies would want to reduce the risk for their shareholders and there lies a need for the market. The main purpose of futures markets is not to serve the traders but to help the connect the consumers and producers and for many of these parties only long term futures makes sense.


On Nov 05 09:28 AM Fred Banks wrote:

> Interesting. I just finished explaining to a gentleman that there
> is no liquidity in the oil futures market for contracts with a maturity
> of more than 6 months, and often less, and now I read in the above
> that it is possible to buy futures for 5 years.
>
> Somebody said that there is a fool born every minute, but I think
> that every second is more appropriate. Don't they teach people anything
> at all in those store-front universities on Wall Street or Rodeo
> Drive.

2008 Nov 07 12:43 AM