Wednesday, March 29, 2006

Investing in Oil: Evaluating Several Options

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.


Jason Godesky said...

I'm reminded of Denmark and Canada jockeying for control of unnamed rocks in the Arctic Ocean, anticipating the opening of the mythical Northwest Passage as global warming melts the ice caps.

I'm reminded, too, of Stalin's expectation, "When we hang the capitalists, they will sell us the rope we use."

Jeff Vail said...

At some point, the problem shifts to this: how to transfer "wealth" from one system (where it is about to be destroyed) to the next (where it will perservere). Peak oil represents, in my opinion, an unprecedented opportunity to build wealth in this system. The trick will be deciding when to affect the transition between systems, and to prevent "wealth" in one from getting stuck on the wrong side of the divide.

So, in response to the (implied question of the) value of "investment" in the face of collapse, I think that one of the themes of this post holds particularly true: the value of a hedge. Learning primitive skills is a hedge, just as speculating in oil is a hedge. We just don't know what will happen--after all, the rapture could sweep us all away tomorrow. OK, maybe I won't be taken along for the ride. The optimal result is that a Peak Oil play pays off and leverages efforts in the next step--transition...

gilemon said...

This is a freaky article...
I'm still struggling with myself to find a good reason that would make me invest in any oil related business. And here you come with this.
But I’ll be strong! No no, no oil. I’ll stick to medium, Vivendi, mass opiate and the whole MMORPG shit. This is where communism is going to strike back. Aoooo!
For real. No need of cars if you can reach level 60 and fly around.

technician said...

Any relation with the Mystery of Bruce Lee's Death?
Enter the dragon?

Anonymous said...

Have a look at how Newmont Mining is handling future oil prices. They've invested heavily in Canadian Oil Sands Trust COS.UN when it traded in the $40s CAD. Its now trading at $160+...

Unlike most oil companies COS.UN has a reserve life index measured in decades.

Market Participant said...

The best way to take advantage of peak oil is to invest in both clean energy and oil/coal/gas resource companies.

IMHO the best way to play this would be to invest in the ETF's IGE (Goldman Sach's Natural resources) which is mostly Oil and Oil service companies, and PBW which is the Powershares Clean Energy ETF. As oil supplies dwindle, the shares of non-oil energy companies will rise leading to a smooth hand off.

Even more compelling IMHO is Peak Water, when the world runs short of the original liquid asset: water. So far this year the PHO Powershares Water ETF is up over 15%. I've written an article about this investment idea for my blog. You might be interested, in checking it out.

PHO -- Water ETF as a liquid asset

Market Participant

Jeff Vail said...

My concerns with investing in oil & oil services ETFs or other funds is mentioned above...basically, I DO think that they will perform well in the short term, but not in the mid to longer term. Similarly, renewable energy returns will be based on the ability of a robust economy to spend to purchase those solutions--something that is not very likely when the subsidy of very cheap hydrocarbon energy that underwrites our economy goes away...

Peak Water may face similar problems--those funds will only return as long as people have the ability to PAY for that water. The advantage of water may be the lower elasticity of water demand compared to the elasticity of demand for other items...

Market Participant said...

I think the hand off will be smooth. My thinking is that as conventional oil sources get depleted, it will become practical to extract less conventional oil sources like tar sands and coal conversion.

Depletion of oil is more of a problem for those who collect oil royalties (think Saudi Arabia) than it is for XOM who will just go somewhere else or change gears to switch to oil upgrading technologies to refine low quality oil like tar sand tar or Venezuelan bitumen.

So we arent going to see a sudden price shock, but a more gradual 8%/year rise in oil prices. There is an equilibrium point because if the economy falters then demand for oil will go down.

Peak Water is similar, as the price of water goes up, capital will be mobilized to upgrade and expand water infrastructure. Unlike Oil, water isn't an exhaustible resource.

Market Participant

Anonymous said...

How can typical investors buy oil futures? Is there a ticker symbol to use at ameritrade?

Anonymous said...

If you don't know how to invest in futures, you shouldn't be investing in futures. Pedantic but true.

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