Does One Need to Invest in Oil to Benefit from Expensive Oil?

Two months ago, Tom Konrad told us how he'd dipped a toe into the black stuff (i.e. bought the OIL etf) on grounds that current supply destruction related to the depressed price of crude oil would eventually lead to the same kind of supply-demand crunch that led oil to spike during the 2004 to mid-2008 period.

If you need evidence that the current price of crude is wreaking havoc in the world of oil & gas exploration, look no further than Alberta and its oil sands. The oil sands contain the second largest oil reserves in the world after Saudi Arabia, but more importantly will account for the lion's share of incremental supply as conventional oil production continues to decline.

The province's economy, which had been growing at a breakneck pace for the past five years, has come to a grinding halt: employment insurance claims grew by twice the Canadian average over the past year; personal bankruptcies jumped by 61%; and home foreclosures are on the rise. This is the result of significant project cancellations that will no-doubt limit Alberta's ability to ramp-up output once prices climb back again.

It is thus no surprise that Cambridge Energy Research Associates and others are warning about the economic hazards of curtailing investments into conventional and alternative energy.

Alt Energy & Fossil Energy

Oil being the most followed of the energy commodities, it is no surprise that it is receiving most of the media attention. Arguably, natural gas and coal prices should matter more to alt energy investors than oil prices: according to REN21, of the $71 billion invested in renewable energy in 2007, 47% went into wind and 30% into solar PV. Both technologies are used for power generation (investments into transportation alternatives are comparatively small) and, in the U.S., coal and natural gas are the dominant fuels in power production. The relentless focus of the popular press and other pundits on the the economic case for alternative energy being closely tied to the price of crude oil is thus mostly misplaced.

Case in point, last November, a reader wrote me with a correlation analysis conducted over a 5-year period (or, where there wasn't five years' worth of data, since inception). The correlation coefficients between the returns on crude oil and those on alt energy securities were as follows: GEX, 0.19; PBW, 0.14; TAN, 0.18; and the index underlying FAN, 0.19. These are, by most measures, pretty low correlation coefficients. Given the reader's reputation, I trusted the numbers.

Nevertheless, in alt energy investing as in life, perception is often reality. Given the many signs pointing toward a rapid escalation in crude prices - demand can and will rebound far quicker than supply - I decided to re-explore the relationship between fossil and alt energies. If a strong positive correlation can be found between alt energy investments and crude oil, natural gas and coal investments, there may not be a need to dip a toe into the black (or colorless) stuff at all - one can focus on alt energy alone and still enjoy the ride up.

In order to verify this, I ran a basic correlation analysis with the daily returns on the KOL (coal), OIL (crude) and UNG (nat gas) ETFs/ETN on the one end, and the daily returns on the alt energy ETFs on the other. I got the return data from Yahoo Finance using the Adjusted Close prices that include dividends and splits. Given the results above from our reader's analysis, I only went back six months to see if the (lack of a) relationship still held.

OIL and UNG track the prices of futures contracts in the underlying commodities, so they are pretty decent securities to use to estimate the returns on crude and nat gas investments. KOL, on the other hand, tracks a basket of coal company stocks. It's the closest thing I could find but it's not ideal as stock returns don't necessarily track commodity returns. For instance, large mining firms will often sell a high proportion of their output through fixed-price contracts, preventing them from benefiting from sudden surges in spot prices.

The boxes delineate general alt energy ETFs (ICLN to GEX), the solar ETFs (TAN, KWT) and the wind ETFs (FAN, PWND). There aren't notable differences between the ETF categories, with the most significant differences being between the fossil fuel ETFs / ETN and the alt energy ETFs.

The relationship between alt energy stocks and coal stocks appears relatively strong. However, in the absence of return data on coal, it's hard to tell whether investing in alt energy stocks (or coal stocks for that matter) is an optimal way of playing increasing coal prices. Given the structure of the coal market, with significantly less involvement by purely financial actors than in oil or natural gas markets, this is a hard one to play for retail investors, although data appears to suggest there is a play.

Though the correlation appears to have strengthened somewhat between crude oil and alt energy investments in the last six months, it remains weak enough that if someone wants to play a return to expensive oil they are still better off dipping a toe (or even an entire foot!) in the black stuff. The same holds for nat gas.

This quick and dirty analysis wouldn't withstand close methodological scrutiny. My only intent here was to see whether these relationships were worth exploring further - they are not. If you want to benefit from crude oil and nat gas price increases and have no ethical qualms about it, invest in them directly!

DISCLOSURE: Charles Morand has a long position in TAN.

Comments

[a. palmer jr.:]

Canada would have even bigger problems financially if the United States would ever charge them for their defense. I know we don't actively patrol Canada like we do South Korea and others but I think it is well know why nobody tries to invade Canada! And Canada has the gall to charge Penn West investors 15% in addition to US taxes. Talk about taxation without representation!

Mar 29 02:15 PM

[ksmithdc:]

Interesting read, thanks.

Mar 29 02:46 PM

[Mad Hedge F...:]

No wonder oil is doing well. More than $19 billion has poured into commodity funds since January 1, $4 billion more than was seen during all of last year. This explains why my beloved copper soared 35%, while gold jumped 9%. Buy hard assets, sell paper ones.

Mar 31 06:39 PM

[reverse mor...:]

It would be oh so easy if we had a crystal ball, but then that would yet one more screen we stare into relentlessly. The fact that oil is rising, or falling can (at least to a degree) be tied to the seasons of the year and the planned or actual travel plans of most Americans.

Last summer, all of us staggered from the prices, no matter our income level. Interesting how they fell come election time, or, as I mentioned above, was that simply the Fall, and travel less eminent in our minds.

I'm not (sadly) invested in oil, though I did take a stab at futures awhile back, of course things headed in the opposite direction, as if waiting for my option purchase.

I don't know if I'll see it in my lifetime, but I yearn for that car from "Back To The Future", that runs on what's left after good dinner, now that would really be something to see AND invest in.

Mar 31 10:10 PM