A number of readers have written to ask how they can pursue my crude oil futures investment strategy, which I first wrote about here.  Let me recap the strategy:

   1. The strategy’s objective is primarily to protect the portfolio in case oil prices rise so rapidly or so far that the global economy is endangered causing stock prices to plummet.  (For further color on the possibility of this scenario, please re-read Charlie Maxwell’s recent interview.  I highly recommend it.) 

   2. The reason we need such protection is that the portfolio is designed in large part to benefit from higher oil prices, but it still is a portfolio of stocks.   If the stock market (remember, that is a market for stocks, not values) were to fall precipitously, all stocks would be impacted, even those that benefit from higher oil prices: the “throwing the baby out with the bathwater” phenomenon that is familiar to investors who have been around for a while.  So the risk is that we could see our underlying assumption of higher oil prices fulfilled but our investment value hurt instead of helped. 

   3. A secondary objective is to profit as the price of oil moves up strongly but not disastrously over the next few years.  This is not a strategy designed to profit from short term (week to week or even month to month) moves in the price of crude, which I am not in a position to predict.   I do believe, however, that the 30%+ compounded annual increase in the oil price over the past three years is not an accident or a temporary phenomenon that will be reversed by a “reversion to the mean.”  I think it is highly likely that the price of oil will tend to increase at significant rates (more than 10% per year) every year going forward.  To help understand why I say that, read the areas called Investment Philosophy, and Peak Oil.

The way I have implemented the strategy is to own options on long term futures contracts.   Specifically, I have concentrated on contracts expiring from late 2012 through late 2015.  I own calls on contract with strike prices in the range of $100 to $120. 

The advantage of owning options on futures contracts rather than the contracts themselves is, obviously, that the downside risk is limited to the price you pay for the options.  So if something should happen to cause the oil price to plummet to, say, $75, the option price will decline but not anywhere close to the decline that will be experienced by the value of the futures contract itself.  This is important in part because it allows the option holder to hold on to his option through what will no doubt be a temporary decline in the oil price.  When the price eventually recovers and goes on to $150, $200 and beyond, the option holder will maintain her position.  That is why this is an investment strategy, not a speculation strategy.

The way an investor can make the specific decisions on which instrument(s) to buy is, like anything else, to do some comparison shopping.   Find out the price of options at various strike prices and various expiration dates.  Then decide which option(s) suit your risk/reward tastes.    

If you want to pursue the options on futures strategy but do not presently have an account at a firm that trades futures contracts and options on futures contracts, you will need to find such a firm and open an account.  Information on futures firms is easily available on the net, or you could ask your current stock broker for a recommendation.  If you have a “private client” relationship at a bank or investment firm, they should also be able to solve this problem for you in one way or another.

Tags: energy investments

This entry was posted on Saturday, February 23rd, 2008 at 10:49 am and is filed under Investment Ideas. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.