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Energy Inflation Hedge
Old 12-07-2010, 05:06 PM   #1
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Energy Inflation Hedge

Please share your opinion on this.

I have been concerned that oil prices will do what they did in 2008 again over the next several years as the economy picks up with China and India continue the rapid pace of development.

I am not interested in trying to hedge against energy inflation because energy costs are embedded in everything we buy (from gasoline to food).

However, I would like to stick with something I understand (or at least think I understand). So that rules out derivatives, directly owning commodities or Commodity ETFs, etc.

The Vanguard Energy (sector) fund is mainly invested in companies that are involved in the production and exploration of oil and natural gas.

It seemed to track fairly well with the rise in oil prices back in 2008... because of their profits.

I was thinking that I might buy the Energy Sector (go long) as a hedge against energy inflation.

I am considering investing enough in the sector (I am working on the amount to invest... it would be a small % of the portfolio) so if prices take off over the next several years, the gains would offset the energy inflation of our household spending for say 5 years or 10 years. I would do this as a tactical allocation. If the value jumps to a certain level of gain, I would probably average out of the position to lock-in the gain. Ultimately, the gain would be spent to offset the extra inflation that hits our expenses (gas prices, food, etc).

The risk would seem to be that the energy sector may under perform for a while... At worst, I might lose a little. But going long probably means I won't lose big as long as I do not need the money for the next 5 years or so .

  1. Do you think oil and gas prices will continue to rise when the economy recover?
  2. Do you think this is a reasonable way to try to hedge energy costs for our household spending?
  3. Do you think it can work by taking a tactical approach is a good idea for this investment?
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Old 12-07-2010, 05:17 PM   #2
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Absent fooling with futures, etc., I think this is a reasonable way to hedge energy costs. I do something via positions in some individual equities.

If oil does another moonshot, I think you will not have issues with energy equities tracking it. In fact, there may well be leverage to energy prices embedded in energy equities. When energy prices ramp up, close to 100% of the increase falls to the bottom line of producers, so you may see energy equities rise faster than energy prices in a big spike. That argues for a small (5%?) Allocation to make your desired hedge.

As for the direction of prices, I dunno. But I like to have a hedge on.
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Old 12-07-2010, 06:40 PM   #3
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Quote:
Originally Posted by chinaco View Post
...The Vanguard Energy (sector) fund is mainly invested in companies that are involved in the production and exploration of oil and natural gas.

  1. Do you think oil and gas prices will continue to rise when the economy recover?
  2. Do you think this is a reasonable way to try to hedge energy costs for our household spending?
  3. Do you think it can work by taking a tactical approach is a good idea for this investment?
I have a modest stake in VGENX in my Roth IRA. No complaints about its growth so far.

1. Yes.
2. Not qualified to answer.
3. Ditto

I can say that it is usually a sure thing that gas/oil prices will go up over time. How that all translates from energy company profits to stock valuation is anyone's guess.

Want to see where gasoline pump prices are going?
Gas Prices - MSN Autos
You can change the zip code at the upper right of the map display box.
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Old 12-07-2010, 07:36 PM   #4
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I have had Vanguard Energy since 1990 and I have been very happy with the returns .
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Old 12-07-2010, 09:34 PM   #5
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Guess most would agree that oil prices at least will continue to rise, even if in some discontinuous fashion. So, over a long enough time frame (as oil literally runs out) prices will rise. I don't see any technology that will (quickly) replace oil for quite some time. And, of course, higher prices will be the main reason we will find another technology - not because we're running out per se. Will that lead to higher oil company stock prices? (See my soliloquy below.)

Having said that, the discontinuities I mentioned are difficult to predict. Those companies who lived through the last oil shock probably have some pretty decent plans to save on oil usage during the next major run up. I saw this happen at my old Megacorp during 74/75 and 79/80. You'd be surprised how much less oil you can use if it doubles in price - or someone fears it will. Additionally, we're always surprised how much oil can be found if the price goes high enough (SD recently found so much oil, it could be the new Texas IIRC).

As an aside to maybe make a point, or maybe not, or more likely 'cause I like the sound of it: I have a question I always ask folks when they complain about oil prices/supplies, drug prices/patents, commodity prices/supplies, etc. being "manipulated" by the various companies. I ask them how many shares of these companies do they own. They always say "none" (I'm serious - no one has ever said they own the stock unless, i.e., it's in their 401(k) and they don't know for certain.) So then I suggest that either they must be named Stewart (as in Stewart J. Pidd) or else they really don't believe the companies have the power to manipulate prices. If they did, they would go buy all the stock in those companies they could afford (maybe on margin!)

Okay, I mention this to point out that I don't believe most (maybe any) companies can manipulate their prices for long, so supply will eventually drive prices, including stock prices if companies know how to take advantage (not manipulate - well, maybe just a little for a while). So, if you think, long term, supply will be short, this could be your (and my) last chance to try this gambit. Wish us luck. I'm seriously considering it again. Thanks for the idea to the forum.
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Old 12-07-2010, 10:00 PM   #6
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1. Yes
2. Yes.
3. That probably wouldn't be my approach. I'd just rebalance this with all my other holdings rather trying to deliberately guess when it has appreciated enough and jump out of the position. If it gets bid up a lot more than my other holdings (due to higher fuel prices or expected higher fuel prices) then I'd automatically be selling some shares, and when the stocks get cheaper again (relative to my other holdings) then I'd automatically be buying some more.
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Old 12-07-2010, 11:47 PM   #7
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Quote:
Originally Posted by chinaco View Post
Please share your opinion on this.

  1. Do you think oil and gas prices will continue to rise when the economy recover?
  2. Do you think this is a reasonable way to try to hedge energy costs for our household spending?
  3. Do you think it can work by taking a tactical approach is a good idea for this investment?
1. Yes
2. Yes
3. Just because I THINK energy prices will rise, doesn't mean I am willing to bet my life and future on it. I don't plan to change my diversified, proven-to-be-robust-in-2008, portfolio and asset allocation.
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Old 12-08-2010, 04:09 AM   #8
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Old 12-08-2010, 04:38 AM   #9
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My OP had some contradictory statements about my goal (one sentence state the opposite of my goal).

My goal is to hedge against the impact of energy inflation on our household spending.
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Old 12-08-2010, 04:39 AM   #10
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That covers part of it... but wood chips aren't very tasty as a food substitute!


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Old 12-08-2010, 05:28 AM   #11
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1) Yes
2) Yes
3) I currently have approximately 8% of my portfolio in a combination of Vanguard Energy and individual energy stocks. I've held Vanguard Energy since 1993. No complaints so far.
I also heat my passive solar home with wood. It's been a good way to control our personal energy expenses for the past 30 years.
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Old 12-08-2010, 08:06 AM   #12
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1) Yes.
2) Yes.
3) Maybe. It is just another asset class. See others' comments above.

My customers are in the energy business and Dirty Oil feeds my family.

I had Vanguard energy as one of my asset classes for quite a while. I have since changed it for a few individual energy stocks split between the US and foreign as I have fooled my self into imagining that I can pick stocks in an area I know something about. I had become disgusted with obvious non-performers dragging down the index. It seems to be working OK for me.

But energy and health care have always been specific (and equally weighted) asset classes in my portfolio.
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Old 12-08-2010, 08:12 AM   #13
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Vanguard Energy is a good fund to hedge personal energy inflation. It is also a decent hedge against longer term $US loss of purchasing power.

Petroleum prices above $90 (and gasoline above $3.00) have a recessionary impact on the US economy. We are at that level now. That's not a reason to not invest in energy, but it might be a reason to open a smaller position now and plan to add some move over the next year or two.
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Old 12-08-2010, 08:21 AM   #14
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I'm curious as to how we would analyze this, mainly because I think it may be a good idea, I'm just not sure how to approach it. Off the top of my (first coffee) head, I think we'd need to estimate:

1) How much energy prices actually affect our spending. Since there are all sorts of things affecting prices of goods, I don't think it is simple to parse out energy cost impacts. Gasoline, oil for heat, natural gas might be pretty easy to track, but probable a pretty small % of the total budget. It seems you are looking more for energy price impact on all goods - groceries go up because shipping goes up, etc.

2) Correlation of a fund like the Vanguard one to those prices.

3) Do the arithmetic to figure how much of the fund we need to hold to offset changes in spending. If it changes 1% for every 1% change in our spending, we only need to hold as much as our annual spending. Now, factor expenses if significantly different from your base holdings.

4) Harder Impossible factor - is this hedge going to provide more return than our overall AA? If we don't have some strong feelings that it will, why not just skip it(W2R raised this viewpoint ealier)? If we do have strong feelings, why not just invest in it, rather than hedge? It isn't risk-less, just because you form a neutral hedge. You could miss the opportunity cost that energy prices actually go down from here. Plus the risk that your hedge just does not perform as expected.

I looked into straight Natural Gas futures a few years back. I decided (maybe wrongly) that a few hundred dollar variation in my heating bill wasn't worth trying to chase down a hedge. My hedge is a sweater

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Old 12-08-2010, 08:25 AM   #15
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While we're on the subject of energy, I'd be interested in others' thoughts regarding other areas of the energy sector, i.e. electric and gas utilities, power plant and power line construction, energy infrastructure in general.

As a nation, we face a lot of challenges with our aging power plants and electrical transmission systems.
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Old 12-08-2010, 10:11 AM   #16
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I think one consideration is that since the crash of '08-09, there has been an extremely high correlation between stock prices and oil prices; indeed, I think the correlation is unprecedented. There's not been much difference between owning energy ETFs and ETNs and owning a stock index fund in terms of moving up and down together.

And in reality, I think that if this speculation trend continues where oil prices spike on any good economic news, we have effectively put a lid on how strong a recovery we can expect.
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Old 12-08-2010, 10:33 AM   #17
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I think one consideration is that since the crash of '08-09, there has been an extremely high correlation between stock prices and oil prices; indeed, I think the correlation is unprecedented. There's not been much difference between owning energy ETFs and ETNs and owning a stock index fund in terms of moving up and down together.
I take this to mean you're never, ever investing in USO again? And this time you really mean it?
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Old 12-08-2010, 04:27 PM   #18
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Back when oil prices going up caused the market to go down I created a 10% allocation for energy/resources equities. I think global competition for resources will be heating up along with improving economies. Whether future oil/stocks correlations are positive or negative I think a little extra weighting in global energy/natural resources looks good.
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Old 12-08-2010, 08:26 PM   #19
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The Energy sector is about 11% of the S&P 500 (ref)

I don't know if that is a sufficient hedge. Two points I can think off
- Energy costs inversely affect a large portion of the remaining sectors. How big is this effect?
- What is the correlation between energy prices (inflation) and your annual expense.

I don't plan to create a hedge. Too complex for me - and where do you stop? A hedge for food prices, health care, taxes, booze?
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Old 12-08-2010, 09:12 PM   #20
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A technical writer I admired, once wrote a book on investing. He 'closed the circle'. If he spent X on electricity, he bought enough utilities to pay him a dividend of X, and so forth.

If I had the $$, I would think about doing that, too.
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