How do you bet? (Updated)
Let's say that you are very concerned about oil depletion. Not just concerned, let's say that you are Highly Vested in some response to The End of Oil; maybe you own a biodiesel plant. I think you should try to be as profitable as possible for two reasons: one, so that you can plow the profits back into the business, and two, to send a signal to other fence-sitters to enter the fray. You are basically making a bet that oil prices will rise, and you should profit from that outcome.
High petroleum prices will not only drive more people into your arms, they will also temper demand through a variety of mechanisms. You probably see that as a good outcome even if it doesn't have an effect on your wallet because it reduces greenhouse gas emission and other pollution and may have other effects you perceive as beneficial. Therefore, you should also be concerned that prices may go down because lower oil prices will allow people to relax as they did after Saudi Arabia relaxed their embargo in the mid 80s. That means more pollution, more dependence on oil, and perhaps a setup for a crash (if you believe such things).
You aren't certain that oil prices are going to be higher. Let's say that you are only 90% certain that oil prices will go up in the future, meaning (leaving out other possibilities) that you are 10% certain that they will go down. This could be a real problem for your wallet, your business, and for mankind. What should you do?
You should bet that oil prices will decline by hedging your much larger bet that they will rise. You can do this by buying a put option on a contract for delivery some time in the future.
Let's say that oil is currently $60, and you think it could go to $90, but it might go to $30. You are already vested in a bet that it will go to $90 with your biodiesel plant, so you invest a much smaller sum into put options at $60. If oil goes to $90, you are covered. If oil goes to $30, you exercise or sell the option (I'm' not even going to tackle the math on what strike prices or contract prices because (A) I'm not qualified, and (B) your eyes would glaze over). You then use the proceeds (60-30=30, multiply by the number of options) to keep yourself in business through what you think could be a temporary bear run for oil - maybe you live off it, maybe you subsidize biodiesel prices, maybe you plow it back into the plant to increase the profitability.
Of course, buying puts for delivery at the current price is the same strategy you might pursue if you thought all of the peak oilers were flat-out wrong and that oil prices are eventually going back down. Ironic, no?
This discussion on EconBrowser is good - many interesting points about oil futures trading.
Update: As it turns out, there was an article in today's WSJ (sorry, pay site) that described the success of the mirror image of my suggestion. Airlines are in a constant gamble that oil prices will stay flat or decline because rising prices can't be passed on to customers easily. For one thing, the airlines are in tight competition with each other, and for another, they also face competition with buses, trains, and automobiles. Southwest perked up the markets today on news of 41% higher earnings this last quarter. How?
High petroleum prices will not only drive more people into your arms, they will also temper demand through a variety of mechanisms. You probably see that as a good outcome even if it doesn't have an effect on your wallet because it reduces greenhouse gas emission and other pollution and may have other effects you perceive as beneficial. Therefore, you should also be concerned that prices may go down because lower oil prices will allow people to relax as they did after Saudi Arabia relaxed their embargo in the mid 80s. That means more pollution, more dependence on oil, and perhaps a setup for a crash (if you believe such things).
You aren't certain that oil prices are going to be higher. Let's say that you are only 90% certain that oil prices will go up in the future, meaning (leaving out other possibilities) that you are 10% certain that they will go down. This could be a real problem for your wallet, your business, and for mankind. What should you do?
You should bet that oil prices will decline by hedging your much larger bet that they will rise. You can do this by buying a put option on a contract for delivery some time in the future.
Let's say that oil is currently $60, and you think it could go to $90, but it might go to $30. You are already vested in a bet that it will go to $90 with your biodiesel plant, so you invest a much smaller sum into put options at $60. If oil goes to $90, you are covered. If oil goes to $30, you exercise or sell the option (I'm' not even going to tackle the math on what strike prices or contract prices because (A) I'm not qualified, and (B) your eyes would glaze over). You then use the proceeds (60-30=30, multiply by the number of options) to keep yourself in business through what you think could be a temporary bear run for oil - maybe you live off it, maybe you subsidize biodiesel prices, maybe you plow it back into the plant to increase the profitability.
Of course, buying puts for delivery at the current price is the same strategy you might pursue if you thought all of the peak oilers were flat-out wrong and that oil prices are eventually going back down. Ironic, no?
This discussion on EconBrowser is good - many interesting points about oil futures trading.
Update: As it turns out, there was an article in today's WSJ (sorry, pay site) that described the success of the mirror image of my suggestion. Airlines are in a constant gamble that oil prices will stay flat or decline because rising prices can't be passed on to customers easily. For one thing, the airlines are in tight competition with each other, and for another, they also face competition with buses, trains, and automobiles. Southwest perked up the markets today on news of 41% higher earnings this last quarter. How?
"Southwest has secured financial hedges that limit 85% of its fuel costs during the year to an equivalent average oil price of $26 a barrel. That saved Southwest $196 million in fuel costs in the quarter, reducing the increase in Southwest's per-gallon jet-fuel expenses to 25%, compared with twice that for competitors."More here, here, and here. The first is an article questioning whether failure to hedge is a breach of fiduciary responsibility, the second is Southwest's annual report, and the third is an academic article on hedging strategies for jet fuel. Another reason to keep flying Southwest.
Labels: energy
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