Tuesday, May 09, 2006

hedging the pump

Feeling the pain of rising fuel costs? Oil is around $70 a barrel and with instability in the vast majority of large oil producing regions (Iraq, Iran, Saudi, Nigeria, Venezuala, Russia) causing supply shortfalls I think we're all painfully aware that oil is very unlikely to decline to the $15 - $20 per barrel with equivalently low gas prices we've seen over the last few years.

So what can you do? How about locking in the price of gas at something reasonable? This is essentially what energy companies do today. They will buy gasoline in the futures market as a hedge to lock in a particular price point. I'm not familiar with the details of how the big guys do it but have at least the beginnings of an idea about how you and I can do it.

Let's say oil producing regions stabilize and production goes back up, enough to make gas fall to $2.00/gallon. Also, in our sample scenario assume our hedger (H) has a car that gets 20mpg and drives 15,000 miles per year. With a little 3rd grade math that comes to 750 gallons of fuel and at the current price would be a spend of $1500/year. Let's also assume our protaganist can find a stock in the equities market that moves in a highly correlated fashion to either oil or gasoline (company A). H purchases $1500 in company A's stock. Now if gas prices rise by 10 or 20 or 50 percent, H's stock will also rise in lockstep. The critical point now lies in profit taking and averaging down. I haven't got all of this worked out yet, but am thinking that if H were to take profits around 5% intervals over the initial purchase price and average down by buying more stock when the stock falls on 5% increments from the purchase price, discounting transaction fees and taxes, H's total fuel costs - stock profits + stock losses would end up with an average cost per gallon near the locked in price.

Anyone out there have more ideas on this?


annarbor87 said...

there are a few problems with the analysis. the correlation of pump prices to integrated oil producers' stock prices (or downstream E&P companies, for that matter) are highly tenuous, and oil futures or the USO ETF are no better. I haven't checked the XLE ETF but this might be the best proxy out there (but still giving rise to significant basis risk). also, in your analysis the consumer should never be buying stock, regardless of whether the stock falls or rises. in your hypothetical case the consumer would lay out $1500 up front, purchase the proxy hedge (XLE or whatever), and then liquidate the hedge throughout the year as money is spent on gas. a lower gas price at the pump, assuming correlations hold, means a lower sale price on the hedge, while a rising price at the pump means a higher sale price on the hedge. that said, transations costs on such a small hedged amount would be significant and likely overwhelm any benefit of hedging to the average consumer.

Anonymous said...

Why not try oil futures. That's what the oil companies would do. It's been a while since I played in this market, but I believe you would want to sell a put to cover you cost should the price rise. You'd collect the time premium as long as oil prices stay at or above the current price.

The strategy is probably more risky overall than the risk of just paying more at the pump. Remember, oil companies can always pony up the tanker load of oil they trade on -- you won't have that option.

Dan Ciruli said...

This is only tangentially relevant, but I remember reading at some point that one of the wisest things Southwest Airlines did over the last few years was hedge on fuel prices. It's one of the things that has kept them profitable as other airlines go Chapter 11.

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