Short-Term Hedges for Your Energy Bets

by Aaron Levitt | August 23, 2012 1:35 pm

Over the long term, it’s a pretty reasonable assumption that energy prices will continue to climb as growing global populations generate rising demand. At the same time, much of the planet’s easy oil has been found. This fact has driven exploration and production (E&P) firms to the ends of the earth in search of new hydrocarbon sources. These unconventional fields aren’t cheap[1] to tap and will ultimate create higher sustained prices.

However, the short run is a whole different ballgame. So far this year, we’ve seen crude oil prices shoot up past the $100 mark, only to collapse back in May. The fracking revolution has also played havoc with  natural gas prices, which fell to historic lows in April as inventories continued to build in the face of dwindling short-term demand. Then, expansive drilling efforts ceased, and natural gas prices shot up more than 60% higher over the next three months.

The point is, over the short run so many factors contribute to pricing that it can be a daunting task for investors to keep up with all that the action.

Currently, it seems that those factors are pointing to lower energy prices for the next few months, even though benchmark prices have kept working their way higher again lately. For investors with some serious coin in the oil and natural gas sectors, now could be a good time to employ some short-term hedging.

Slowing Growth and Dwindling Geopolitical Risks

The reasons for a coming short term fall in energy prices can be really summed up in two points: slowing global economic growth and a slightly less hair-trigger environment in the Middle East.

Europe’s continued debt woes are clearly having their ways with global demand.[2] As the eurozone grapples with austerity and social imbalances, estimates for the continent’s economic activity and energy usage has drifted lower. That lower growth is now beginning to spread across the globe and affect other nation’s energy demand.

Here in the U.S., the sluggish economy has sent petroleum consumption down 2.7% in July compared with the same time last year. Likewise, gasoline demand was down 3.8% during that same time period. Now, emerging-markets leaders like China and India are also struggling to keep up their past growth stories.

Then there’s Iran. The threat of war between the West and Tehran over its nuclear ambitions has been a constant overhang[3] in the energy markets for roughly a year. Threats to close the Strait of Hormuz as well as the resulting retaliation from the U.S. and Israel have added a $10 to $20 premium to the price of Brent crude. So far, military action hasn’t occurred, and each day the likelihood of such an event drifts lower. Uncertainty is still the operative word here, but at least tensions haven’t been steadily rising.

All in all, the short-term picture for energy prices is pointing downward. Luckily, there are plenty of ways to profit from the energy market’s downside and protect one’s portfolio.

Finding Those Hedges

With some analysts[4] calling for crude oil and natural gas to fall all the way down to $32 and $1.75, respectively, shorting the direct commodities makes sense. Both the PowerShares DB Crude Oil Double Short ETN (NYSE:DTO[5]) and ProShares UltraShort DJ-UBS Natural Gas (NYSE:KOLD[6]) make it easy to bet against the pair.

The PowerShares ETN goes short a basket of crude oil contracts and has been quite effective at realizing any dips in oil’s price. For example, when crude last plummeted during the beginning of the Great Recession, a $10,000 investment in the ETN would have grown to almost $90,000. The ProShares ETF does the same for natural gas prices.

As for these funds’ use of leverage[7], which is generally risky, I’m OK with it. Remember, these are short-term plays on some short-term price action. This is exactly the kind of situation that leveraged exchange-traded products were designed for.

It stands to reason that if the prices for energy commodities drop, the companies that extract those fuels will realize lower profits[8] and potentially see their share prices fall. The Direxion Daily Energy Bear 3X Shares (NYSE:ERY[9]) is the most heavily traded short energy producer fund available for investors, and it replicates a -300% daily return[10] on the popular Select Sector Energy SPDR (NYSE:XLE[11]). Investors gain targeted short exposure to various E&P firms, oil-services stocks as well as pipeline operating companies. Recently, the ETF bounced off of its 52-week low.

Finally, for investors who would rather not short the market, going long on sectors that will benefit from lower energy prices makes equally as much sense. After all, the less money consumers need to spend at the pump[12], the more they can spend at places like Starbucks (NASDAQ:SBUX[13]). The SPDR S&P Retail ETF (NYSE:XRT[14]) gives investors an opportunity to bet broadly on the discretionary sector, which tends to rise in periods of falling oil and gasoline prices.

The overall lesson here is that regular retail investors don’t need to be bullied by short-term price swings in the energy market. The previous ideas are just examples of how to hedge your exposure and wait until the long-term upswing begins again.

As of this writing, Aaron Levitt did not hold a position in any of the aforementioned securities.

  1. unconventional fields aren’t cheap:
  2. ways with global demand.:
  3. constant overhang:
  4. some analysts:
  5. DTO:
  6. KOLD:
  7. these funds’ use of leverage:
  8. realize lower profits:
  9. ERY:
  10. -300% daily return:
  11. XLE:
  12. spend at the pump:
  13. SBUX:
  14. XRT:

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