Street Patrol
Recent articles:
• 4 womens clothing stocks for happy holidays, 9/30/2004
• 3 stocks for scaring up Halloween profits, 9/23/2004
• 3 absolutely positively good air-freight stocks, 9/16/2004
More...
| | Street Patrol
4 ways to protect your oil profits
If oil prices fall, oil-related stocks are likely to follow. But there are ways to protect your gains without selling everything outright.
By Robert Walberg
If you were smart enough to load up on energy stocks or funds when the year began, and smarter still to hold them throughout the year, then you're sitting on some big paper profits. It might be tempting to unload some of these stocks now, especially since crude prices this week eclipsed $51 per barrel for the first time. But given still-strong global demand, dwindling U.S. reserves, ongoing Middle East unrest and a series of disruptions in several key oil-producing nations, why would you?
You don't have to. There are ways to hedge your energy investments without actually selling. These strategies will enable you to capture profits if the stocks continue to rise, but provide some protection if they fall.
The main reason some experts tell investors to sell oil-related investments now is because they say prices cant keep going up. Granted, oil prices might back up a bit over the short term, but the underlying conditions that prompted this years dramatic rise remain in place. Barring a major downturn in demand or a surprise rise in supply, neither of which is likely in the foreseeable future, crude will remain well bid into next year.
As long as it remains above $40 per barrel, oil-patch earnings will easily surpass current estimates. More often than not, positive earnings surprises translate into higher stock prices. So, its tough to make a compelling case for selling energy stocks or funds.
Which sectors make the best hedges?
Nevertheless, it might be prudent to take steps to secure your gains against the unexpected. Just as its unwise to sell too soon, its also imprudent to expose big gains to unnecessary risks. Would you invest in a new car or house without insuring it against theft or fire? Of course not. The same principle applies here.
One possible way to hedge a portfolio of energy stocks or funds from a surprisingly significant drop in crude prices would be to add exposure to sectors that traditionally do well when oil prices fall. Airlines come quickly to mind. Their second biggest operational expense is fuel.
The airline stocks that would benefit the most from a drop in crude are long-haul carriers such as AMR (AMR, news, msgs), Delta Air Lines (DAL, news, msgs) and Continental Airlines (CAL, news, msgs). Unfortunately, all of these carriers have serious problems that lower crude prices alone cant fix. Buying stock in poorly managed companies with broken business models is never a good idea, even as a hedge.
Related news on MSN Money
Other industries that you would expect to benefit from declining energy prices include trucking and air freight. Just as it is to airlines, fuel is a significant operating cost for both groups. Unlike airlines, however, these industries are (generally speaking) financially healthy. So an investment in trucking companies such as Yellow Roadway (YELL, news, msgs), J.B. Hunt Transport Services (JBHT, news, msgs) and Old Dominion Freight Line (ODFL, news, msgs), or air-freight giants United Parcel Service (UPS, news, msgs) and FedEx (FDX, news, msgs), would seem to be better choices as a hedge for your oil stocks or funds.
Important correlations
If only it were that simple. Before you rush out and load up on any of these stocks, its important to understand the potential negatives to such a strategy.
First, you need to know the correlation between the hedging sector and movement in oil prices, especially when oil declines. For example, both trucking and air-freight stocks have performed quite well recently despite the rise in oil prices. Each group has strong fundamental reasons for bucking the rise in fuel costs, and each might continue to climb should crude prices drop. However, theres no guarantee that'll happen and that makes understanding the historical relationship between the sectors and oil so important.
Its also difficult to judge exactly how much these stocks would move in response to a drop in oil. In other words, if crude prices tumble 20%, will trucking and air freight rally in kind, or will the gains be smaller? And will your underlying basket of oil stocks or funds fall by more or less than crude? Again, you can turn to historical price movement for guidance, but keep in mind that current-day dynamics wont be exactly the same. This information is necessary to determine how much of your portfolio you need to hedge in order to sufficiently protect your paper profits.
Finally, there's the cost of such a strategy. Lets assume your portfolio of oil stocks is worth $20,000. You might be required to spend as much as 50% to 70% of that total in order to provide an appropriate hedge.
Using futures or options as a hedge
You can also hedge your portfolio by playing the futures market. Oil futures are found on New York Mercantile Exchange (NYMEX), and can be used easily to hedge against a drop in crude prices. A hedge involves establishing a position in the futures or options market that's equal and opposite to a position at risk in the physical market. For instance, a crude oil producer who holds 1,000 barrels of crude can hedge by selling one crude oil futures contract. The principle behind establishing equal and opposite positions in the cash and futures or options markets is that a loss in one market should be offset by a gain in the other market.
Of course, in this instance, were not talking about owning the actual commodity itself, but stocks or funds in energy-related businesses. This makes developing a hedge using futures against stocks a little cumbersome, as investors now need to know the correlation between not only oil futures and spot prices, but also spot prices and the stocks involved so they can get as close to a perfect hedge as desired.
Another potential drawback is cost. The contract size is considerable enough to eliminate many smaller investors. Recognizing this fact, NYMEX created the e-miNY crude oil futures contract, which is the equivalent of 500 barrels of crude and 50% of the size of a standard futures contract. The contract is available for trading on the Chicago Mercantile Exchange GLOBEX electronic trading platform and clears through the NYMEX clearinghouse. Even so, to hedge a portfolio of $20,000 could require an investment of at least that much (depending upon the correlations).
Options drawbacks
Similarly, options could prove costly. Though a more-direct means of hedging (as you would use options against the very stocks that you own), options could prove cumbersome if youre trying to protect a diverse basket of oil stocks. Buying or selling options against all the stocks would be unnecessarily costly; if youre holding five to seven energy stocks, you might want to pick one or two to trade options against.
For example, you might choose to buy out-of-the-money puts against a large-cap industry leader like Exxon Mobil (XOM, news, msgs). Exxon January 2005 puts (.XOMMW) with a strike price of $47.50 per share can be purchased today for about $100 per contract. Lets assume you bought 10 contracts for $1,000. If the price of your $20,000 energy portfolio dipped by 10%, or $2,000, Exxon would need to fall to $44.50 per share, or about 10% from current levels, in order for you to make back the $2,000 in the options market.
Of course, the price would need to decline between now and expiration in January or the entire options investment would be lost. This is how this strategy can get expensive over time. Writing, or selling, options is another alternative, but it gets tricky when you have a diverse basket of stocks; and if the market moves the wrong direction, you could be forced to liquidate your positions.
Put a stop to it
A more simple means of ensuring that your oil-related gains dont disappear, or worse yet turn into losses, would be the use of stop orders. In this case, were talking about using sell stops, which are orders placed below the market price. Once the stop price is touched, the order is treated like a market order and is filled at the best possible price. Note that in very fast markets, that price could fall well below the actual stop price.
Nevertheless, this is a relatively simple, easy-to-understand way for an investor sitting on large gains in the oil patch to protect against giving back much of that profit. Aside from simplicity, this approach also is cost effective because it doesnt require additional out-of-pocket expenses. The trick is determining where to place the stop to guard against a drop in crude without being so tight as to kick you out of the stocks during normal corrective activity.
In theory, hedging a profitable portfolio of oil stocks sounds like a great idea. In practice, such a strategy can be costly and somewhat complicated. Though the downside risk to crude prices would seem to be limited now, the more conservative among you might want to consult your financial adviser to explore which of the above strategies for protecting profits makes the most sense for you.
At the time of publication, Robert Walberg neither owned nor controlled shares in any equities mentioned in this column.
|
