Invest in futures contracts?

[Ted]

In a sense, entering into futures contracts is not "investing," because a contract is initially opened with zero value, and has an expected return of zero. In other words, it's theoretically a gamble with a 50-50 chance of winning or losing, not counting transaction costs.

Having said that, however, futures can be used conservatively, to hedge against events that would cause a person's other investments to lose purchasing power.

Long term, it's virtually certain that the price of crude oil will continue to rise, as world demand expands and readily available supplies are drawn down and sold at a higher price by the countries that control them. Eventually, I foresee the price rising to the point that gasoline is largely replaced by hydrogen or some other renewable fuel in cars, and the remaining oil is used mostly for aircraft.

A way to hedge against this eventuality is to enter into long-term futures contracts to purchase crude oil. Contracts are available as far in the future as December 2008, with the current price being about $23 per barrel. This represents a substantial discount to the spot price of about $27 per barrel. Since one contract is for 1,000 barrels, owning one contract commits a person to purchase 1000 barrels for $23 per barrel. Realistically, the potential loss might be around $8,000 if the price would temporarily drop to $15 per barrel, but the potential gain is much greater. For example, if the price of oil went to $40 per barrel, the gain would be $17,000 per contract. That would certainly help to defray the increased price of gasoline and heating oil.

The major concern about trading futures is psychological -- that people approach it like gambling and get "hooked" on short term trading rather than long term hedging. But stock ownership can have the same pitfalls.

[Michael]

So why not just invest in low cost sector mutual funds to hedge? With funds, you cannot lose more money than you invest, like you can in futures. Personally, I don't see much need to hedge against gasoline price increases, since I can just drive less. Health care seems more essential to me.

[Ted]

Response to Mike:

Why not invest in low-cost sector funds to hedge?
That is an alternate approach, but the "catch" is this. "Energy" related funds or "natural resource" related funds invest largely in oil companies. To the extent that these companies own oil reserves, they will tend to profit from increasing oil prices. But most oil reserves are owned by other nations who sell to the oil companies, so rising prices will be passed through to consumers without particularly benefitting those companies.

Furthermore, when oil company profits increase above their "normal" mediocre levels, there is a political hue and cry to tax away the so-called "windfall profits." Remember what happened in 1973? So why would a rational investor want to invest very much of their assets in oil companies?

Rising oil prices will be the economic system's way of forcing people to conserve a dwindling resource. The only way that society as a whole can protect against being forced to sharply curtail its travel and space heating is to develop alternate energy sources and more energy-efficient vehicles and buildings. But barring any radical breakthrough in technology, all of these alternatives will cost more than oil/gasoline presently costs.

So anyone who hopes to do things in the future like drive extensively, heat a large house in a northern climate, own a power boat (like Dory 36), or travel by air, had better anticipate having to pay substantially higher costs to do so.

Being "long" on an oil futures contract is a way to hedge against that possibility. Like any other financial transaction, it involves risks, but as I pointed out, the risk of potential loss is limited. The flip side is that the potential gain from being "long" a contract, and the potential loss from being "short," is unlimited.

As a matter of public policy, I advocate shifting federal taxes away from things like corporate profits and employment (i.e., FICA) and onto crude oil, to accelerate the shift to energy conservation in a way that will best utilize market forces. But knowing the way that our democracy fails to deal with crises like our dependence on oil from politically unstable parts of the world, I'm doing what I can personally to protect my own future energy needs.

[Michael]

Ok, I see your point in the case of oil. My house uses natural gas for heating, and I don't drive much, so if anything I would hedge natural gas. Since the domestic supply of natural gas seems to be reasonably plentiful for the next few years (the time limit of LEAPs), I will most likely just limit myself to hedging health care with a low cost sector mutual fund.

You are correct that price is how the market allocates scarce resources, and also correct that our political system will not allow a significant tax on oil in the near future. In view of this, I don't see oil permanently increasing in price enough to force hydrogen powered cars until the oil actually starts to run out. Still, with advancing technology making previously hard to reach oil available, this could be sometime in the next few decades, rather than few years. Of course, a political shift could create shortages if oil producing countries align against us. That is harder to predict though.

[Ted]

In the short to intermediate term. the price of oil certainly is radically affected by international events. Right now we are seeing it go up, but it is also possible that events could cause an international "glut" that could cause the price per barrel to drop to perhaps $15, where it was a few years ago. So anybody who is long on an oil futures contract should be prepared to put up the collateral necessary to hold onto it for the long term, if necessary.

Rising oil prices will tend to cause natural gas prices to rise also, since they are substitutes to some degree -- especially for heating buildings. I wouldn't expect the price of natural gas to rise as quickly, but a person with a big home heating bill could still use natural gas futures as a hedge. Although they are not available as far into the future as crude oilo contracts, a person could simply "roll over" their contract(s) into longer term contracts as they approached their settlement date(s).

The idea of retired people "hedging" against increasing costs of health care is attractive, but I don't know a really reliable way to do it (other than to purchase long-term care insurance). There will certainly be an increased demand for retirement housing, geriatric care, and pharmaceuticals, but there is also a likelihood that these will be financed and thus regulated by government in a way that limits potential profits.