Tapping Into Oil

January 01, 2006

Ahh, oil-that slippery, slimy, smelly sludge that powers our global economy.

Oil has always entranced investors. We have pet names for it black gold, Texas Tea. We follow its price on an intraday basis. We have our favorite oil aphorisms, most of which boil down to this: "If oil is up, the markets are down."

John Serrapere's survey article on oil in this issue is enough to frighten any self-respecting equities bull and send him running for the noncorrelated comfort of commodities exposure. As Serrapere makes clear, the era of cheap energy is over, and investors would be wise to reposition their portfolios to reflect this new reality.

Serrapere's investment platform uses a mixture of exchange-traded funds (ETFs), commodity-indexed products and energy stocks to gain a nuanced exposure to the new energy reality. And I'm not going to quibble with that approach. But sometimes, for some investors, the simplest approach makes the most sense. And if the defining feature of this new reality is that oil is hard to come by, then the simplest answer is to own … oil.

The trouble with this strategy is that, historically, it's been both difficult and expensive to gain real exposure to oil. Unless you own scrubland in Texas, there's just no easy way to get at it. You can't just go out and buy a few barrels of crude and stuff them under the mattress. But fortunately, the times they are a changing, and financial innovations a re bringing us closer and closer to that reality.

Tapping Into Texas Tea

Traditionally, the most popular way to speculate on the price of oil has been through the futures market. Futures are legally binding contracts to buy or sell a commodity at a given price at some point in the future. For instance, I might enter into a futures contract to buy 10,000 barrels of oil for $50/barrel on October 20, 2006. My hope is that oil is selling for more than $50/barrel when the deal comes due, so I can profit on the trade.

In theory, if I held that futures contract to maturity, I'd receive 10,000 barrels of oil delivered to a port in Oklahoma. But most traders don't actually take physical delivery of the oil - they sell the contract before the delivery date.

These contracts can extend out as much as seven years into the future, with monthly contracts available for each of the next 30 months.

The market for oil futures is huge. Nearly 53 million con-tracts traded hands on the New York Mercantile Exchange (NYMEX) last year. Crude contracts also trade on the International Petroleum Exchange in London, the Tokyo Commodities Exchange, and other exchanges around the world. It is truly a global market. In the United States, a "mini" contract also trades on the NYMEX, at half the dollar value of a full contract. Crude oil futures are the most actively traded commodities futures contract in the world, and the NYMEX market is the deepest and most liquid.

The trouble with futures contracts is that they' re not friendly to the individual investor. Each crude contract on the NYMEX re p resents 1,000 barrels of oil (that's 42,000 gallons, if you're keeping count). At press time, crude was trading for $58/barrel, putting the notional value of each futures contract at $58,000. Even the "mini" contracts trade for $29,000 per stub. That ain't chump change.

You don't have to put up all that money - you can buy most futures with a 5-8 percent margin deposit. But still, there's a lot of money at stake - more than many people want to bite off at one time, and more than fits in most balanced portfolios. Moreover, there are technical challenges to buying futures contracts: For instance, futures can only be purchased in a dedicated futures account, not in most securities accounts. And if you're buying futures, you should really take the time to learn how the market works - you better know what "backwardization" and "contango" mean, or you're going to get your shirt handed to you. Finally, because futures are time dated, traders must "roll over" their holdings periodically to maintain long-term exposure, selling one contract and buying a new one with a later expiration date.

In other words, futures are a great solution for many traders, but they' re not plug-and-play for everyone .

Sophisticated traders also buy or sell options on crude oil futures contracts, providing increased leverage and either income or downside protection on their investments. An option on a futures contract gives you the right but not the obligation to purchase a futures contract at a given date and price sometime in the future .


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