Thursday, October 08, 2009

Revised Strategy for Energy ETFs

So much has changed in energy ETF trading, I feel obligated to write a follow-up to my previous article on the topic. That article, in February 2009, outlined the potential for a relatively safe investment in energy by buying and selling calls on energy ETFs. This was based on the premise that oil and gas were relatively cheap, limiting downside risk. At the same time, relatively high expectations for future prices made it possible to profit by selling call options, while further insuring against the downside. The example I gave involved buying USO and selling 6 month options near the purchase price. As it turns out, all of these options have now been exercised, resulting in a tidy 20% return over a 6 month period, although, of course, owning USO without selling the options would have resulted in even larger gains. But, my objective was good returns for “safe” money…alternatives to low yielding CDs or dangerous bond funds. This objective made the options a critical part of the equation.

While I believe safe, profitable trades are still available in energy ETFs, it is important to note that much has changed since those days:

· Oil has nearly doubled in price, with the result that USO is no longer comforted by the idea that oil prices have little downside. Recent history makes it clear that prices well below current prices are possible, and oil is nearer the upper end of my long term target range than the lower end..
· Natural gas prices, on the other hand, have continued to fall. Over the past few months, I’ve become convinced that natural gas is the energy source with minimal downside due to unsustainable low prices. Therefore, I’ve switched to using UNG as the vehicle for trades. I recently bought UNG at 9. 10. 11 and 12 dollars per share, again selling options just above the purchase price for approximately a 15% premium.
· At recent prices, gas is at multiyear lows, both on an absolute basis and relative to oil.
· But, ETFs such as UNG have become so large that they dominate gas trading, and therefore have problems that make them hard to run efficiently. Recently, UNG has sold at significant (20-25%) premiums to their Net Asset Value. Although currently premiums have shrunk to a more manageable level, it is unclear whether UNG will be able to operate effectively in the current environment. Caution and recognition of this issue is advised

You should also be aware that natural gas has its own peculiarities. Unlike oil, it trades on a more localized, rather than worldwide, basis due to transportation difficulties. This makes the price more subject to local economic conditions. While I expect that over time the U.S. market will come to depend more heavily on LNG, raising prices due to processing and transportation cost and linking the U.S. more closely to world markets, this is not currently the case.

Both supply and demand are significantly effected by the transportation and portability issues of natural gas. Shortfalls cannot easily be covered by importing gas from other areas. Surpluses are difficult to store. Gas is difficult to use for transportation, one of our largest consumers of energy.

Natural gas is considerably cleaner that other hydrocarbons. Over time, I see a move toward natural gas from coal and oil. I also see gas moving toward a more worldwide market. All this will result in higher prices But this progression will be slow, and for now supply exceeds demand in the local market, pushing storage to its limits and pushing prices lower. Now is the time to take advantage. Just be aware of the issues with both UNG and natural gas in general and be cautious.

Monday, January 26, 2009

Low Risk Investment in Oil and Options

In my last post, I mentioned investing in oil and gas by using exchange traded funds (ETF) and covered call options. As a result of comments and discussions since, I realized my explanation of this strategy was rather cryptic, especially for those with little experience in ETFs or options.

I'll state up front that I'm not an options expert, but this strategy is relatively safe and easy and as a result could well meet the needs of a large number of investors right now. So, let me explain in a bit more depth what was suggested.

My premise was that oil and gas, at prices below $40/barrel and $5/mmbtu respectively, seem to be at a point where the downside is likely to be limited and some potential up side seems like a good bet.

Obviously, one way to play this scenario would be to buy oil and gas. But, actually owning oil and gas is difficult for most investors. A relatively convenient alternative is to own ETFs such as USO and UNG. These funds attempt to track the prices of oil and gas respectively and are easily traded like stocks on the NYSE. So, owning these ETFs are a reasonably good proxy for owning oil and gas directly.

I believe that owning these ETFs is likely to be a good investment over the next few months or years, but it involves both signficant risks as well as significant profit potential. However, with the recent fall of the stock market, my normal investment system, Dollar Cost Averaging on Steroids (see the link to Personal Finance Guru on the right for more details), has essentially all my risk capital tied up in stock index mutual funds and I do not believe it is the time to sell these funds.

A greater need right now is for relatively safe and attractive investments for cash which may be needed over the next 3-5 years. Alternatively for some, it might be a place to hide from the markets, although this doesn't fit with my strategy currently. That is where selling covered call options on the mentioned ETFs comes in.

In effect, they are a way to trade some of the risk as well as some of the higher potential profits for some risk protection and a higher probability of lower but reasonable profits. To do this, you would buy (or own) one of the ETFs, and sell covered call options on the ETF for the future. Because of general expectations that oil and gas will be higher in the near future than they are today, the sell price of the calls is relatively high.

Let me give an example of a trade I recently made to illustrate. I purchased 100 shares of USO for $29.65 per share. I then immediately sold covered $31 call options for July 2009 for $4.40 per share. The result is that if prices remain steady I'll pocket the $4.40 and keep my ETF shares, netting about 15% ($4.40 on the $29.65 investment) for the six month period. If the ETF trades above $31 during the period the options may be exercised and I would be forced to sell the shares for $31 and pocket the $4.40, resulting in a gain of about 19% ($4.40 + $1.35 on the $29.65 investment) in six months or less. If the fund falls, I would still have some lessor profit unless it falls more than 15%, or lower than $25.25 ($29.65 - $4.40). Of course, the ETF could fall lower than $25.25, in which case I would lose, but would lose $4.40 less than if I had just purchased the ETF without selling the option.

Hopefully this example makes clear how this process can help meet objectives for a good return with less risk, a common objective for a lot of cash today. Note though, that it is not entirely risk free, and you have to trade potential higher returns for the reduced risk. This process, of course, can work for virtually any stock or ETF investment. But the high expectations that exist in the market for future energy prices (as confirmed by the oil contango and relatively high option prices), combined with my belief that oil prices are unlikely to drop too much further for any sustained period, make this a relatively attractive investment. And, it is a relatively simple process that is easy and practical for most investors.

If you wanted to get just a bit more sophisticated, it is relatively easy to taylor this strategy to your own shade of bearishness, bullishness or agressiveness. If you are more bearish, you might sell the options for a lower strike price (say $28 for the above example) which would increase your downside protection while giving up some upside potential. If you are more bullish, you could sell the options at a higher strike price (say $35 for the above example), which would decrease the downside protection while increasing the upside potential.

I'd love to hear comments, either on something I've missed or a better alternative. But, for my low risk cash, this strategy seems hard to beat.

Wednesday, January 21, 2009

Opportunity in Energy Investments

As discussed in my previous post, significant events are in play in the energy world. The cost of both electricity and gasoline seems set for serious increases as a result of Obama energy policies. Both the timing and the implementation details are outstanding questions, and many other factors are at work. But, with so many changes apparently on the horizon, it makes sense to consider the implications and opportunities.

Let's review. Democratic leaders seem strongly inclined to reduce use of coal and gasoline. While the demand and cost for both is relatively low right now as a result of economic conditions, the coming of peak oil would normally increase cost of both coal and oil if demand returns to growth rates of the past 80 years, since a large majority of world energy supply is from these two sources.

However, substantially increased taxes on gasoline will reduce demand for oil, thereby depressing oil prices, relatively speaking. Transportation demand, coupled with high gasoline prices, will substantially increase demand for the two practical alternatives, electricity and natural gas.

Meanwhile, decreased use of coal, or alternatively, use of carbon sequestration, will depress demand and prices for coal. At the same time, carbon sequestration and/or substitution of higher cost alternatives will drive up the cost of electricity, which could already be stretched by transportation demand.

So, what will be the replacement for coal and the source of this increased electricity demand? Solar and wind supplies will be increased, but even dramatic growth in these resources will fall far short of demand for many years. Nuclear appears to be gaining ground, but substantial increases will be at least 10-15 years away due to plant permitting and construction times. Natural gas is clearly the only viable solution for the next decade. Substantial supplies are available, although largely at higher prices. It is relatively cheap. It is relatively green. Combine its role as a viable alternative for both electricity and transportation, and higher demand and prices seem to be a slam dunk for natural gas.

So, where to put your money? Conservation will be a great investment, with both higher gasoline and electricity costs. Unless you have a relatively well insulated and efficient home, conservation investments there will return in excess of 10% annually, even based on current prices. This would be enhanced if I'm right about the direction of electricity and natural gas prices. Transportation is a bit more tricky, since many current efficiency alternatives are not currently viable and the winner of the technology race for transportation efficiency is not yet clear.

But, let's say you want to look at more conventional energy investments. Coal, oil and natural gas are all relatively cheap right now and are essentially the only alternatives available in the near term for the majority of energy supply. So, I'd expect somewhat higher prices for all over the next year or so, as demand returns . But, over time, both coal and oil will be at a disadvantage. Meanwhile, natural gas will see substantial increases in demand and price.

To play the above in conventional energy companies, I'd favor natural gas producing companies over those who focus on coal or oil. Electricity generating companies are not as cheap as resource companies and are still largely regulated. Meanwhile they will need to deal with the complexities of shifting resources while highly dependent on difficult capital markets. As a result, I expect utilities to continue to be the relatively low return, conservative business they've traditionally been.

Manufacturers of solar panels will likely grow, but huge growth already seems to be priced into their prices. Meanwhile, their products are not currently competitive and the technology winner is still unclear, making investments there risky.

Another alternative is to invest in oil and gas exchange traded funds such as USO(oil) or UNG(natural gas). When natural gas is below $5/mmbtu and oil is below $40/ bbl, the downside of USO and UNG seems limited, and I expect both will rise over the next year or two, although as noted above I would lean toward UNG in the longer term.

Related to USO, you should also be aware of an extreme contango (oil futures selling for significantly more than current prices). As a result, many are storing oil while selling it on the futures market. This results in somewhat higher prices today, while putting downward pressure on near term future prices for oil, although the volumes are small relative to the overall oil markets. This situation, as well as robust prices for call options reflects a prevailing wisdom that oil prices will be higher in the near future. As a result, opportunities exist in these funds if you would like to lower the risk involved with being long in them. I've recently been buying these funds and selling 6 month calls with strike prices near current prices for about 15% of current price. With this method I am able to lock in about 30% annualized returns if prices remain the same, while breaking even when prices fall by 15%. I consider this a good alternative to virtually nonexistent yields on CDs or money market funds for cash I may need over the next year or two.