How to implement a long-term trade on oil?

Question

I believe that one of the most compelling case of long-term trade is the long position on oil. Fundamentally, it seems quite clear that demands is going to grow in the future as emerging markets start using more and more energy, whereas supply is likely to be limited as the resource are vanishing or at least are more expensive to extract.

I am aware that the oil prices are fluctuating a lot and that now might not be a good time to enter the trade, but my question is more abstract. Assume that oil reaches a price that can be considered interesting to get in. I assume I want to make a long-term trade, i.e. over 5 to 10 years. I can see essentially 3 possibilities:

1. Buy physical oil and store it
2. Buy oil futures and carry it
3. Buy oil firms' stocks

The first alternative is costly and requires quite an infrastructure for storage. The seconds will suffer from the contango situation and the cost of rolling. The third one suffers from the equity risk of the underlying firms which is not related to the oil prices per say.

Is there another implementation I didn't think about which could be a good way to get exposure to energy prices.

Answer 1

If I may share some wisdom that was passed to me and that I insisted I test empirically and through painful lessons learned to take seriously and trust in:

• There is nothing that is guaranteed in life (aside us all having to die). You already sound like you made up your mind on the long side of the oil trade. Have you considered that not the demand for oil of emerging markets will be the biggest variable int his equation but substitute products. The U.S. may well be energy sufficient in a couple years, fully independent off Saudi oil. Then there is other energy sources that may push oil well into the teens or 20s in 10 year's time. I am just urging you to consider that.

And here to your points:

1) It has been a very profitable trade for some of the large trading houses, so profitable that Goldman, MS, and other banks setup whole department to charter tankers simply to hold oil and leisurely cruise around betting on higher oil prices. But yes this is not a one-man show.

2) Forget that for anything other than trading short-term. Look at the curve 1-2 years out and I think we agree.

3) This I think is your best bet and the precise reason guys like Paulson bought gold companies (well lets not talk about his most recent blunders). It allows to trade in size and allows to get involved without the infrastructure required to hold the physicals. You can always strip out the equity component through an index hedge, and I think as long as you reasonably diversify you should be sufficiently insulated from unsystematic risk as well.

In summary, to go long oil as part of a longer-term trade I do not see a way around buying oil exploration companies or equities with price return profiles that are highly correlated to spot oil price returns. Most all derivatives and ETFs are adjusted for the price of hedging future cash flows through forwards or futures.

Answer 2

My answer is to go with option 2, but go long the long-dated contracts. Looking at the forward curve for WTI crude, one can buy crude, say, for 5 years out at $83 per barrel. Not only you can avoid the monthly rolls, you can take advantage of the current medium-term/long-term backwardation in crude.

Answer 3

What about a total return swap on the price of oil?

In general, search for things with a high correlation or cointegrated with oil and check what risks you would take on compared to physically holding oil and see how you can minimize them. For instance, in the oil stocks case, you could short equity futures to only take energy stock risk instead of general equity risk. There are some currencies that are correlated with oil, but it is rather indirect. Alternately, you could create a basket that is correlated with oil and try to minimize the non-oil risks of the basket.

You could also consider an options strategy. If you think oil will be significantly higher, then you could use a knock-in call to reduce the initial cost. Then again, you will also face risks with an option strategy.