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When inflation really revved up late last year – causing everything from food to gasoline to skyrocket in price – he decided he wanted to get a real feel for the energy price surge. So he made sure to gas up his Ford Fusion with the same grade fuel at the same Wawa pump each time his gas gauge reached “E” – and took note of the price each time.
Granted, TradeSmith won’t be winning the Nobel Prize in Economics for this fuel-filling foray, but the findings were still pretty stunning. Want a sample? My colleague paid $3.959 a gallon for “Super” on Nov. 24, $4.189 on Feb. 19, $4.559 on March 5, and $4.799 on March 11.
That’s a gain of more than 20% in less than four months. And it’s part and parcel of the worst U.S. inflationary surge in 40 years – meaning most Americans have never seen prices skyrocket like this. I know I haven’t.
Indeed, everywhere I look – in anecdotes from my family and friends, and in my travels for TradeSmith – I see and hear about the pain that inflation is inflicting.
My career as an entrepreneur also makes me a professional problem solver. And that means there’s only one question to ask here: We all know inflation is bad. But do you want to sit back and take it – or battle back?
I’m all for battling back – for solving the problem – and one great way to begin is by adding energy-related investments or trades to whatever else we’re doing with our money.
And we’re going to start with a detailed look at oil and natural gas – and moves you can make right now.
When Obvious Moves Aren’t the Best MovesVery quickly, I want to address the elephant in the room.
Yes, you can buy oil and gas companies to gain exposure to those underlying energy commodities.
And most of you know there are ETFs out there that track the price of oil and natural gas.
If that’s the way you want to go, consider the upstream exploration and production companies. The SPDR S&P Oil & Gas Exploration & Production ETF (XOP) is a great place to start, since its holdings include such companies as Devon Energy (DVN) and Occidental Petroleum (OXY).
Two of the most popular ETFs out there are the United States Oil ETF (USO) and United States Natural Gas Fund (UNG), which track the daily price movement of oil and natural gas, respectively.
Unlike another popular commodities ETF – the SPDR Gold Trust (GLD), which actually holds physical gold in a vault – oil-and-gas ETFs use futures products to track the price of the commodity they’re focused on.
And that creates a hidden danger.
You see, because of the way futures are structured (with all other things being equal), USO and UNG will lose value over time.
There’s a good reason for this: Futures contracts are like options in that they have specific expiration dates. And for most commodities, the further out you go in time, the more expensive the futures contracts become. This is the premium built into those contracts.
And just like options, futures contracts will slowly lose that premium as they approach expiration.
To keep the ETF going, the USO and UNG will take all their expiring futures contracts, sell them, and buy the next month’s contracts – a process known as “rolling.”
Since the contracts they buy are typically more expensive than the ones they sell, the funds lose money. In fact, if you look at the price movements of oil or natural gas and compare them to the commodity, over time, they can and will diverge.
In the parlance of the investing profession, this is known as a “tracking error.” And it’s why funds like these aren’t buy-and-hold investments.
There’s still another major problem with these ETFs. And it came to a head back in 2020.
As I mentioned earlier, these products use futures to track the price of oil and natural gas.
While options give the owner the right (but not an obligation) to buy or sell the underlying asset like these ETFs (calls to buy and puts to sell), futures obligate the owner to buy or sell.
That’s not a problem with cash-settled futures like the VIX or S&P 500. Those simply pay out the difference between the buy/sell price and the price at expiration.
However – and this is not the case with options — deliverable futures require the owner to take delivery of the product.
This happens with “hard assets” – like gold, copper, and oil.
In the summer of 2020, all the oil storage in Cushing, Okla., was full. So if you’d snapped up a crude oil futures contract, you had to drop it before expiration. Otherwise, you’d end up storing crude oil in the family swimming pool – or your backyard jacuzzi. (In 2020, desperate traders were actually renting supertankers and storing crude at sea.)
When there’s storage capacity available, this isn’t an issue. Traders will just rent space for the time it takes to roll their contracts.
Since they couldn’t do it at that time, anyone who owned crude oil futures contracts that expired that summer needed to sell them or take delivery of oil.
The USO owned roughly 25% of all the crude oil contracts out there.
And that meant they had a lot of futures contracts to sell.
That sent crude oil futures negative by more than $40 — meaning USO was paying people to take their futures contracts — a terrible “sale” price, especially when the USO had to buy the next month’s contract at somewhere around $30 to $35.
Consequently, that led to the USO losing a ton of value in one week.
How could you trade these ETFs?
I would consider using options, whether buying calls and puts outright or using spreads.
That way, you can define your risk and use the commodity’s excess volatility to work in your favor.
However, there’s another leveraged instrument you may want to consider: futures contracts.
Directly trading futures contracts yourself is a more flexible approach than dealing with ETFs, and these leveraged instruments even offer a few advantages over options.
Back to the FuturesI realize that some of you may not be intimately familiar with futures products.
But let me assure you: They’re nowhere near as daunting as they might first appear.
Futures work a lot like options – but with a few important distinctions, including:
- You can only trade the current month’s expiration, next month’s expiration, and usually one or two others.
- Futures trade from Sunday at 6 p.m. Eastern to Friday at 5 p.m. Eastern with a break each day from 5 p.m to 6 p.m. Eastern.
- Futures products trade in a separate account from equities and options.
- There is only one central exchange that clears futures trades.
- The leverage for a futures product is static and doesn’t change as it does with an option when the price of the underlying asset moves.
We’re going to focus mainly on the “mini” and “micro.”
Now, futures products are “leveraged” – which means you only have to put down a fraction of the value you control with a contract.
For example, a mini oil futures contract controls 500 barrels of West Texas Intermediate (WTI) crude.
Each $0.025 movement in the price of oil equates to a change in value of $12.50 per contract.
To initiate this trade, you need as little as $250 to day trade or $2,550 to hold it overnight.
Micro oil contracts control only 100 barrels of oil per contract. Each $0.01 movement in the price of oil equates to a change in value of $1.00 per contract.
Margins for micro oil contracts are much smaller and can be as low as $50 to day trade and $510 to hold overnight.
Here’s a breakdown of the contract specs for oil futures that you can find on the Chicago Mercantile Exchange’s (CME) website.
Here’s something you need to know: Only the standard contracts require physical delivery. The mini and micro contracts are “cash settled.” So if you hold a contract at expiration, your account is credited or debited by the difference between the price at which you bought/sold the futures contract and the closing price at expiration.
For natural gas, there are only standard and mini futures contracts available.
The standard natural gas futures contract:
- Controls 10,000 million British thermal units (MMBtu) of natural gas.
- Each $0.001 change in the price of natural gas equates to a change in value of $10 per contract.
- Settles with product delivery.
- And has day-trading margins as low as $250 and overnight margins as low as $6,400.
- Controls 2,500 MMBtu of natural gas.
- Each $0.005 change in the price of natural gas equates to a change in value of $12.50 per contract.
- Settles in cash (financially).
- And features day-trading margins as low as $100 and overnight margins as low as $1,600.
That said, commodity futures come with all the dangers posed by options and other leveraged products.
So it is crucial that you understand:
- How much the value of each contract changes as the price of the commodity changes.
- Whether the product is cash settled or physically settled.
- And when expiration happens so you know when to roll your position.
This is the most direct way to gain exposure to the price of a commodity.
The real question is, where does the price of oil and natural gas go from here?
There are many reasons to believe supplies will tighten even further. But will demand start to dwindle? You can bet that my colleague will be watching.
Email me and let me know your thoughts. While I can’t answer your emails individually, I promise to read every one.