Natural hedges

abnormalreturns
April 9th, 2006

With the summer driving season rapidly approaching the notion of higher gasoline prices is taking hold in the popular press. With stubbornly high crude oil prices and continued economic strength the notion of $3 gasoline is back on the table. The question for consumer/investors is whether there is anything one can do to offset the higher costs?

Jad Mouawad in the New York Times notes two prominent facts about gasoline economics as we enter the summer. The first is that domestic refining capacity remains quite tight with a continuing dependence on importing refined products. The second is that most Americans have not dramatically changed their driving habits even after the scare induced by hurrican inflated prices last year.

Ron Lieber at the Wall Street Journal explores some of the options available to “hedge” their driving exposure. One prominent example Lieber mentions is the new oil ETF (USO). A couple of problems arise in that oil prices and gas prices are not perfectly correlated with additional costs, i.e. refining, marketing, transportation having an important role in the price of gasoline. Another possibility are the relatively new “hedgelets” available over at HedgeStreet.

The vast majority of consumers are better off taking a two-pronged approach to potentially higher gasoline prices. The first is to take inventory of your driving habits and see if there are ways in which you can improve. Most people cannot afford to trade in their car solely for the purposes of lower gas consumption, but if a new car is already warranted then thinking about fuel economy is probably a good idea.

The second prong is available to investors. Investors can ensure that their portfolio has a meaningful weight in energy companies including oil production and refining. A sustained rise in the price of the petroleum complex would in all likelihood positively impact the share prices of these companies.

One can think of this as a “natural hedge.” This approach is not active in the sense that you go out and directly purchase an interest in gasoline futures. This passive hedge is potentially less effective, but is an easier fit for the vast majority of investors. This approach can be extended to other areas as well. For instance a weighting in international equities (or fixed income) can serve as a hedge against a lower dollar. A meaningfully lower dollar would lead to higher import prices and higher consumer prices in general. Hopefully these portfolio gains would help offset these economic costs.

Of course every individual is different and every portfolio has multiple goals. However every portfolio is designed to fund future consumption in one way or another. Hopefully the concept of natural hedges can provide investors with another way of thinking about how they can best design their porfolios to best provide for their goals.

For those really interested in the inner workings of the new oil ETF you can read an excerpt from the S-1 over at Seeking Alpha.