How to Hedge Oil Prices in Volatile Markets

Welcome to the new pricing environment.

We're already started to see kneejerk reactions to short-term indicators last Friday.

A better than expected jobs report sent crude oil prices higher immediately. The figure was encouraging but not a barnburner. Of course, some massive upward revisions for the previous two months hardly hurt either.

Some of this is the result of investors still gun shy after a massive recession. Now we have certainly had a very nice bull market run and the prospects of another meltdown any time soon are negligible.

Nonetheless, the new drivers of oil prices provide little chance for real dynamics to work themselves out. This is all about reaction. Picture it as the newest investor version of smoke and mirrors.

Today's prospects are very good for the oil sector. Natural gas has pulled back from some heavy gains. Major losses earlier this week were erased on Friday. There is a range forming, and it is likely to remain absent any unexpected developments (largely geopolitical at this point).

Demand will increase as we move into the summer; global levels will rise quicker than domestic in the U.S. or Western Europe. That will provide some upward pressure on oil prices.

Remember as well that, while certain region such as the U.S. have a new largess in unconventional (tight or shale) oil, the full volume of that new production will be more expensive to bring on line. That means the additional extraction will not decrease the overall price.

However, the real question is how to make money if trading is in a narrow range for the near term.

You need to develop a new hedging strategy. Here's how...

Oil Prices: The Market Sector Approach to Hedging

Now the conventional hedge seeks to provide insurance against rapid price increases or decreases. You set up investments providing for a return regardless of which way the market actually moves. Each trading session, you are guaranteed a winner in one direction but a loser in the other.

A portion of the loaf is better than no slice in such an environment.

But how do you set up a convenient hedge when trading company stocks rather than commodities? With commodities you could easily buy a gold play, say SPDR Gold Shares (NYSEArca: GLD), that would rise when gold prices improve. On the other side, PowerShares DB Gold Short ETN (NYSEArca: DGZ) is a short fund and would improve if the gold price declined.

But this is far more difficult if one is focusing on oil companies rather than the oil itself. The approach I would suggest is to hedge using market sectors.

This approach would use producers, midstream, processors, and service companies to provide a better overall picture of the oil picture and improve return when trading is in a narrow range and demand is estimated to increase.

In other words, the picture we could be looking at for the next several months.

Here's How to Approach This

To initiate this hedging strategy, it is better to begin with getting as broad a market exposure relative to the strategy as possible without having to acquire a number of different company stocks.

This is tailor made for the use of exchange traded funds (ETFs), allowing exposure to a large number of companies in a specific segment of the market.

Initially, I would suggest three such segments:

  1. mid-level producers;
  2. pipeline and related service providers; and,
  3. oil field services and equipment.

There are a number of ETFs available, but not all are of the same quality. The two important elements are how reflective the ETF is of a particular area of oil investment. The second concerns the fees charged by the ETF.

The first determined whether the fund is actually representing the segment you are looking for. The second is all about how much your return is paralleling the performance of the underlying shares.

I daily track all ETFs available in all segments of the energy sector. We are about to move into the summer upward cycle in oil and that would be the time you should introduce this hedging strategy. Remember, hedging means you are to expect both winners and losers. There may be unusual trading sessions in which all increase or decline, but this is not the normal outcome.

What you need to do during the period we are entering is to provide your energy portfolio with a base. This use of ETFs is not the only investment approach you will be employing. But it should be able to give you a stable foundation so long as the environment remains essentially the same.

If the market is going to provide us with this narrow trading range, in oil that means we should be balancing operators' field development plans against existing production levels, the offset of pipeline transit to storage, and processing runs against refinery capacity. That would take three well-selected ETFs from my tracking list of over 60.

Stay tuned. Once the dust settles, we'll begin to prepare your oil insurance plan.

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About the Author

Dr. Kent Moors is an internationally recognized expert in oil and natural gas policy, risk assessment, and emerging market economic development. He serves as an advisor to many U.S. governors and foreign governments. Kent details his latest global travels in his free Oil & Energy Investor e-letter. He makes specific investment recommendations in his newsletter, the Energy Advantage. For more active investors, he issues shorter-term trades in his Energy Inner Circle.

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