Posted by: Aaron Pressman on April 10, 2006
One of the new oil ETFs (Symbol: USO) started trading today, allowing investors to buy shares of a barrel of oil without the complications and risks of using the futures market. Already you can see some hysterics who say don’t touch the fund with a ten-foot pole.
In some ways, they’re right. I’m not sure how much success anyone would have just guessing where the price of oil is headed over the short-term. And based on recent conversations with fund managers like Dan Rice of the Blackrock Global Natural Resources Fund (SSGRX), the smarter play may be to buy shares of energy producers that the market is valuing based on much lower than current prices of oil and coal. Rice’s fund owned coal companies like Peabody Energy (BTU) and Arch Coal (ACI) among its top holdings on 12-31-05. That said, there are probably times when the reverse is true and it might make sense to own oil directly instead of the producers. Now it’s an easy swap.
I can also think of at least one way that the existence of the ETF creates a new opportunity for individual investors to hedge, especially in a world of $8 online trading commissions. For example, we paid a couple of thousand dollars this winter for heating oil and it wasn’t even a particularly cold winter. Living in an old, drafty house, we are greatly at risk of higher oil prices. If it had been as cold as 2004, our oil bills would have been positively scary.
What if in the warmer season, I invested that couple of thousand dollars in the oil ETF? Then as I get my monthly oil bills over next winter, I sell down the holdings to pay for heating. If the price of oil falls, I lose money on the ETF but it’s offset by savings in my winter bills. Price of oil rises, I’m covered, even if the price rises a lot. One data point to check first would be the correlation between home heating oil and the raw crude price used for the ETF. I’d guess that they’re pretty close. I’m also not hedged against the weather. Falling oil prices and a warmer winter (a natural combination) would leave me with bigger losses on my hedge than savings on my heating bills. That suggests setting up only a partial hedge.
My costs would be the trading commissions, a percent or so, and the opportunity cost of not having the money in a bank account or money market fund, just a few more percent lost. Since the price of oil could double, that seems like a small price to pay. Some heating oil companies allow customers to lock-in a price for the season ahead of time, which is another possible alternative. That wouldn’t have the weather-related consumption risk though depending on the date and price of the lock-in offer, might be a lot less of a hedge.