Hedging Oil & Natural Gas Stocks With ETF Shorts

Investors who hold oil and natural gas stocks in their portfolio likely find that the movement of those stocks is tied more to the underlying commodity than to the broader markets. Investing in energy stocks can therefore come with sharp volatility that may keep small investors on their toes and awake at night. But the introduction of new Exchange Traded Fund products provide investors a way to keep the overall movement to a minimum.

Example: An investor has a $50,000 long exposure to oil companies and $25,000 long exposure to natural gas companies. To hedge his investment, the investor would sell short $50,000 of an oil commodity ETF, such as the iPath S&P GSCI Crude Oil Tot Ret Idx ETN (OIL), U.S. Oil Fund ETF (USO), Claymore MACROshares Oil Up Tradeable Tr (UCR) or PowerShares DB Oil Fund (DBO), and then sell short $25,000 of the United States Natural Gas ETF (UNG). This effectively gives the investor a neutral exposure to underlying commodity movements, while still enjoying the value added feature of investing in quality oil and natural gas companies, such as buybacks and dividends.

On July 31, 2007, I initiated the following demo trades as a test to this strategy:

Position Name	Shares	Direction	Total Amount
United States Natural Gas Fund, LP (UNG)	244	Short	$-9,984.48
Nicor Inc. (GAS)	244	Long	$9,972.28
United States Oil Fund LP (USO)	172	Short	$-9,996.64
Valero Energy Corp. (VLO)	146	Long	$9,983.48

As of August 31, 2007, the strategy has returned a profit of 5.74% versus a .94% return of holding only the two oil and natural gas stocks, Valero Energy Corp. (VLO) and Nicor Inc. (GAS), over the month. The majority of the profit came from the short position in the United States Natural Gas Fund (UNG), which benefited from a decline in the price of natural gas over the past month.

Although the proposed investment strategy does not fully hedge a portfolio against macroeconomic and firm specific risks, it does significantly lower the volatility that comes with investing in oil and natural gas companies. This strategy also allows investors to take advantage of an inflated commodity price and with oil trading towards its 52 week high this week, investors may choose to use this strategy to lock in that price.

Disclosure: The author does not hold any positions in securities mentioned in this article.

Comments

[Shmoop]

How is 5.74% less volatile than .94%???

[ErnieMontague]

The strategy is one that many people use, and those who do have discovered that there is not necessarily a linear connection between ETF's and equities, particularly in crisis periods, when the USO may be a very speculative ETF and equities may diverge from it considerably. Further the volatility daily is enough to put off even the most experienced investor.

[Bryan Moore]

I think this strategy does provide some merit in keeping overall movement to a minimum while adding some alpha to your portfolio as a whole. Commodity ETFs make horrible long-term investments due to the nature of the premium they pay for the futures contracts; however, the same premium is what makes them an ideal short candidate. While Ernie is exactly right about the commodity (ETF) deviating from that of the oil and gas equities at times, I still feel that, in the long run, this strategy can generate profitable returns outpacing those of an unhedged energy portfolio.

The investment thesis is that oil by itself pays no dividends and is costly to inventory, but one can hedge the price risk of that commodity and allow the energy companies in the portfolio to create value through operating efficiently and through shareholders rewards, such as dividends and buybacks. This can take out the biggest variable in the total movement of energy equity holdings.

If you follow this link (www.iupsmip.com/Hedged...) you can see a graph of the two strategies, showing both unhedged and hedged; it shows the performance of the two strategies over the past month. It is always wise to test a strategy such as this over the long term before putting money towards it, but I felt that it is worthy of mention to other investors to keep in mind for future opportunities.

[ErnieMontague]

I have to admit that the best hedging I have done on ANY of my energy stocks is to sell covered calls and eat the paperwork. While you may lose the stock to call, the premiums are often worth it. I have hedged my entire energy portfolio over the last few months with good results. (aside from the long term dividend stocks I hold).

[Hedgehogger]

I think this whole argument is much too simplistic and doesn't take into account the inherent operating leverage of an oil company - each company will have a different "delta" to changes in oil given fixed vs. variable costs in their operating model and therefore a 1 for 1 short doesn't seem like a very logical suggestion (especially in such a general manner as you mentioned here) - the idea is in the ballpark but what you really want to do is model that operating leverage and then find a company where you can short the futures curve against they're operating exposure and generate abonormally large cash flows given that you can lock in their future selling price (with the only other part of the equation the volumes feeding into revenue and of course assuming you can model the cost structure effectively) from your perspective as an investor - obviously if the company does some hedging internally then you would build that into the model and short less of the forward curve - you could also try to hedge both input and and output futures curves if you wanted a little bit more of a challenge...