Disclaimer: This post in no way constitutes investment advice. It is nothing more than a hypothetical evaluation of the potential returns for a variety of investment possibilities that are linked to the price of crude oil. All of the below scenarios carry considerable risk, and individuals should perform their own research before investing.
There is a growing sentiment that the price of oil will increase—perhaps dramatically—in the next few years as global oil production peaks and begins to decline. There has been a concurrent and growing discussion about what investment vehicles make the most sense to take advantage of this expected increase. This post will look at five separate investment possibilities, explain their fundamentals, and evaluate their respective returns under several possible future-price-of-oil scenarios.
1. Oil-Related Equities: The most common advice, available for free across the internet and cable news channels, is that the best oil investment is in oil companies, oil-industry service companies, or oil-focused mutual funds. There are two opposing forces at work here. As the price of crude oil rises, the profit to be made from existing, developed reserves will increase proportionally. At the same time, as the ability of oil companies to produce oil decreases (or the cost of non-traditional production increases), their profit potential will decrease. Stock price is, theoretically, the total profit of a company for the rest of eternity discounted by the time-value of that profit. In reality it is a much more short-sighted phenomenon. However, at the point at which an oil company’s production, and hence profit, is widely expected to dramatically decline in the foreseeable future, then that company’s stock price will decrease well before their profits actually decrease. For this reason, if one accepts the basic Peak Oil premise, investing in oil companies is only profitable in the short term. Exactly where that crossover occurs will depend on the dynamics of oil production decline, but cannot be objectively evaluated at this time.
2. Oil ETF: This Monday, the AMEX will begin offering an oil “Exchange Traded Fund,” or ETF. This is basically a fund that will track the value of a barrel of crude oil, minus a 0.5% annual management fee. It is primarily an opportunity for smaller investors to add oil to their portfolios without the need to purchase a whole option or future (which start in the several thousand of dollars each), and without the high volatility of those vehicles. Anyone with who can buy and sell stocks on line (e.g. Ameritrade, eTrade, ScottTrade, etc.) will be able to purchase the oil ETF.
3. Oil Futures: An oil future is a contract to pay a certain price per barrel for 1000 barrels of oil at a defined time in the future, normally as far as 5 years out. A future contract has high potential return, but it is highly volatile and one can potentially lose significantly more money than was initially invested. Buying or selling a futures contract is more complicated than simply buying or selling stocks, mutual funds, or an ETF, but is not beyond the capacity of armchair investors.
4. Oil Options: An “option” is when someone pays to have the option to buy or sell a specified futures contract at a specified future price. For example, a call option on a December 2010 oil future at a strike price of $80/barrel means that the option owner has the choice—but not the obligation—to purchase 1000 barrels of oil for $80/barrel in December 2010. So if oil is less than $80 barrel at that date, the option expires worthless. If oil is at $200 dollars a barrel, however, then the option is worth ($200 - $80) x 1000, or $120,000. Options have unlimited potential profit, but you can never lose more than you initially invested. Buying or selling options is about as complicated as buying or selling futures.
5. Related Hedges: There are also a number of related investments that **should** increase in value along with the price of oil. One such related investment is gold, because rising oil prices are inflationary, and gold is a traditional hedge against inflation. However, there are a variety of scenarios where oil could increase and gold could decrease in value, so this is by no means guaranteed to be linked to the rise in oil.
SCENARIO EVALUATION: Below, the relative risk and profit on oil ETF, futures, and options are laid out for a variety of different prices of a barrel of oil in December, 2010. They are calculated using oil, future, and option prices as of 29 March, 2006 (click to enlarge):
A Note on Using Oil Vehicles as a Hedge:
Beyond “investing” in oil (which is, itself, a debatable label—more accurately it is “speculation”), it is also possible to use the above vehicles as a hedge against rising oil prices. Briefly, a hedge in oil will offset the increased cost incurred by each of us as oil prices rise. For example, if one personally plans to use $1000 in oil each of the next 5 years at current prices, then by investing $5000 in the oil ETF you will lock in that cost for the next 5 years. So if oil doubles in price, your cost to use the same amount of oil will also double, but you will recoup that added expense through profit on your oil ETF. Roughly, this is what Southwest Airlines has done (they are hedged through 2010), and is why they remain the only profitable airline. An oil option is the most efficient hedge mechanism because it requires tying up less money to hedge against a given quantity of oil usage, without incurring the risk of losing more than you paid for the option. Such a hedge is valid against several potential future problems: the decrease in suburban home values, the cost of commuting, the cost of home heating and electricity, potential losses in index mutual funds, possible hyper-inflation, potential downturn in the economy leading to unemployment, etc. However, calculating exactly how to hedge for each of our individualized risk-sets can be challenging and imprecise.