Hedging Oil & Natural Gas Stocks With ETF Shorts

Includes: DBO, UNG, USO
by: Bryan Moore

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 (NYSEARCA:OIL), U.S. Oil Fund ETF (NYSEARCA:USO), Claymore MACROshares Oil Up Tradeable Tr (UCR) or PowerShares DB Oil Fund (NYSEARCA:DBO), and then sell short $25,000 of the United States Natural Gas ETF (NYSEARCA: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



Total Amount

United States Natural Gas Fund, LP (UNG)




Nicor Inc. (NYSE:GAS)




United States Oil Fund LP (USO)




Valero Energy Corp. (NYSE:VLO)




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.