An Oil Trader's Dilemma: Stocks or Futures?

02/24/2011 1:00 am EST

Focus: FOREX

Conflict in the Middle East has put crude oil in the spotlight. One expert makes a case for why futures may be the best way to trade the hot commodity.

Perhaps you’ve seen headlines about soaring energy prices, but aren’t sure how to pick the right energy stock(s) to invest in (remember Enron?). Or maybe you aren’t sure about the soundness of the stock market in general and want a relatively simple way to trade your bearish viewpoint.

You can directly invest your views in any number of markets—from crude oil to corn, and even what you think the Federal Reserve’s next move will be—using futures. Most investors are familiar with equities, but futures are still a foreign concept. Futures markets offer many advantages that equity investments don’t. And if you trade equities looking at macroeconomic trends, you may find futures more attractive, or at the very least, competitive with equities.

The profit outlooks for financial, metal, and energy companies are influenced by fundamental factors that are tradable and realized in the futures market. For example:

  1. Interest rates impact the price of financial shares
  2. Gold, silver, aluminum, and copper prices influence metal shares
  3. Crude oil, crude oil products, and natural gas influence the price of energy shares

Futures offer direct exposure to an underlying macroeconomic theme, and management and operational issues of a particular company become less important. Issues of capital structure are likewise not important to futures pricing. And, there is less worry about company-specific shocks, including the actions of analysts.

Benefits Include Capital Efficiency

Futures offer leverage and capital efficiency. Futures have lower margins relative to Regulation T stock requirements. So, less capital is needed to gain target exposure. Keep in mind, leverage can be a positive or a negative for traders: It can magnify gains, but also losses. You need to manage your risk accordingly. Futures may also offer tax advantages over equities. Futures are taxed at a blend of long-term and short-term capital gains, while equity capital gains and dividends are taxed at a higher rate for short-term holders or traders. Please consult your tax advisor for details based on your particular investment strategy.

In addition, with futures, you can more efficiently trade a bearish viewpoint. There are complications with going short on the equities side, but going short is just as easy as going long in futures. Unlike stocks, there is no borrowing of equities or repo issues. And while an equity short must pay a dividend on the stock, a short position in futures does not. Dividends can be costly in financial or energy shares in particular.

Perhaps you already have a portfolio of energy or metal shares—or other sector stocks—and are looking for an effective hedge. Futures are ideally suited for this purpose. There are many sophisticated strategies you can also use with the goal of stripping out some of the commodity price risk.

Energy Futures vs. Energy Stocks

Now that I’ve outlined the basic advantages futures can offer over stocks, I’ll provide more specifics using energy futures versus energy stocks as examples. Let’s dig deeper.

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Naïve analysis implies a relationship between the price of crude oil and natural gas and the price of an integrated oil firm such as Exxon Mobil (XOM), Conoco Phillips (COP), or Chevron (CVX). These stocks should be valued on the basis of production value (the amount of the commodity sold times the price) or value of reserves (the value of the commodity in the ground times the number of barrels of oil in the ground, for example). In each case, the price of the commodity influences the valuation of the stock—the amount of revenue or the value of reserves. However, there are other issues that can drive the price of a stock.

The reason it is naïve rests in the details. For example, the company may be running low on reserves. Thus, if the value of the commodity is not rising by enough to offset the loss in reserves, the value of the company could decline. Likewise, revenues could go down if the number of barrels of crude oil sold cannot be offset by a higher price. In each case, it is possible for the price of the commodity to go up, but the value of the company to go down.

Additionally, there are corporate issues that could cause the stock to lag, even though the commodity rises. These include poor management, actions which dilute shareholder value, and higher costs that cut into margins. In these cases, higher commodity prices don’t necessarily translate into higher equity prices. There are deeper issues below the surface. Some integrated oil names also have chemical and refining operations that may be adversely affected by higher energy prices.

Trading the “Crack Spread”

Refiners such as Valero (VLO) track the “crack spread,” which can be traded using futures. Refiners make money buying crude oil and processing it into gasoline and distillate. The crack spread is usually thought of as buying three contracts of crude oil, and selling two contracts of gasoline and one contract of heating oil. It’s used when crude oil is viewed as cheap relative to the other products. The opposite is also possible: Selling three contracts of crude and buying two contracts of gasoline and one contract of heating oil.

Why would you consider this strategy? You might think the products are more valuable than the crude oil. For example, oil inventories are relatively high, but gasoline and distillate inventories are relatively low due to tight refining capacity. In this case, you would want to buy the products and sell the crude oil, looking for the spread to widen, i.e., there is too much crude oil relative to the products. A refiner, like VLO, will see its profitability rise in this case.

Buying VLO can be profitable because of the widening of the spread, as the company buys relatively cheap crude oil and sells relatively expensive products. But one doesn’t have to be a refiner to exploit the differing fundamentals. A hedge fund or retail investor can mimic the strategy. It is a play on the relationship between crude oil and the products and is based on the fact that each product faces different supply and demand fundamentals. Taking it a step further, the futures market offers you the ability to spread gasoline versus heating oil, or the value of one product versus another. It may be difficult to capture this differential from trading an individual equity, although a refiner would likely shift more weight toward the more expensive product. The crack spread is a type of spread trade in the crude oil complex.

Futures Contract Specs and Margin Issues (as of Feb. 24, 2011)

Crude Oil

  • Contract size is 1,000 US barrels
  • $10/tick or 0.1 = $1,000 per $1 price change
  • Contract value at $85 = $85,000
  • Marked to market daily
  • Margins for Speculator: $5,063 initial and $3,750 maintenance per contract (subject to change at any time)

Mini Crude Oil (E-mini Crude Oil)
  • Contract size is 500 barrels
  • $12.50/tick or 0.025 = $500 per $1 price change
  • Contract value at $85 = $42,500
  • Marked to market daily
  • Margin for Speculator: $2,531 initial and $1,875 maintenance per contract  (subject to change at any time)

Heating Oil
  • Contract size is 42,000 US gallons
  • $4.20/tick or 0.1 = $420 per value of one point
  • Contract value at $280 = $117,600
  • Marked to market daily
  • Margin for Speculator: $5,063 initial and $3,750 maintenance (subject to change at any time)

Gasoline
  • Contract size is 42,000 US gallons
  • $4.20/tick or .01 = $420 per value of one point
  • Contract value at $280 = $117,600
  • Marked to market daily
  • Margin for speculator $5,400 initial and $4,000 maintenance (subject to change at any time)

One final note, you may wonder, “What about energy exchange traded funds?” I won’t get into the mathematical details, but you have to trade a lot more shares to gain the same exposure as one futures contract. And, futures are advantageous over ETFs for the same reasons stated in the beginning of this article—potential tax advantages, greater capital efficiency, and direct exposure to the underlying commodities.

By Nick Kalivas, vice president, financial research, MF Global Research 

Our clients can get a free two-week trial to MF Global Research to hear more market viewpoints from Nick and other outstanding MF Global analysts.

Futures trading involves substantial risk of loss and is not suitable for all investors. Past performance is not necessarily indicative of future trading results. Trading advice is based on information taken from trade and statistical services and other sources which Lind-Waldock and MF Global Research believes are reliable. We do not guarantee that such information is accurate or complete and it should not be relied upon as such. Trading advice reflects our good faith judgment at a specific time and is subject to change without notice. There is no guarantee that the advice we give will result in profitable trades. All trading decisions will be made by the account holder.

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