Good Time To Hedge Against Higher Gasoline Prices?

I just filled up my tank for the least amount of money in a long time. When I first wrote about hedging against rising oil costs, the national average was $3.70/gal and headed towards $4/gal. Now it’s around $2.15. Remember when we were all afraid of $5 gas? Which got me thinking, perhaps now is a good time to reconsider hedging gas prices?

Example scenario: If you drive 12,000 miles per year and your car gets 25 MPG, that means an annual fuel bill of $1,920 with $4 gas. But with $2 gas, your annual bill is now only $960. Makes sense, a doubling of price from $2 to $4 again will lead to a doubling of cost – nearly $1,000 per year.

Now let’s say you buy $1,000 of one of the two major oil ETFs tracking crude oil prices, USO or OIL. (Use a broker with free trades.) If crude oil prices jump again, then the value of these stocks should roughly rise to compensate. If $4/gal comes back, your annual fuel bill would rise by $1,000, but your oil futures stock should also rise by $1,000. You’re virtually fully hedged this way, even if gas goes to $6/gal or higher.

So I suppose being fully hedged means buying as much oil ETF annually as you spend on gasoline in that time. Effectively, you are buying a year’s worth gasoline ahead of time and locking in that price. If gasoline wasn’t so difficult to store for long periods, you could do this manually.

Now, there is no free lunch here. If gas prices drop even further, then you won’t be able to benefit from cheaper gas either. A drop to $1 gas would leave you missing a savings of $500 per year, although I have a hard time seeing it drop that far.

Cost of hedging. Don’t forget, you could have invested that $1,000 somewhere else. If you assume an annual return of 8%, that’s a missed opportunity cost of $80 per year. Of course, we all know now that assuming stable 8% returns is not good. If it would have been held in a bank instead (a more likely scenario), then a 3.5% APY leads to an annual cost of $35, or $3/month.

Hedging is about having a price that you are comfortable paying, so that you don’t have to worry about unexpected price swings. Usually, it is also the case that you are more afraid of a potential rise than a potential drop. Gas prices have been one of the more volatile parts of our budget, and we could use this period of lower prices to build your hedge. Is it worth paying $3/month for such a hedge? I’ll let you decide.

Comments

  1. Not sure if you know much about options, but there are lots of strategies you could take part in to accomplish the same thing you are talking about.

    Right now Jan 2010 USO $50 Calls are trading for $1000.

    Or you could do a calendar spread to consistently reduce your cost basis + benefit from premium, for instance: purchase Jan 2010 USO $60 calls and sell Dec 08 $60 calls and take in $135. Each month you could sell additional calls and reduce your cost basis on the Jan 10 $60s to near nothing while still benefiting from oil rising.

    Of course if oil keeps falling we all have bigger problems to deal w/ since the market cannot move up w/out oil moving up. So would you rather have cheap gas or cheap net worth?

  2. Yes I’m also fascinated by the idea of hedging against home prices and job losses. Got the inspiration from Irrational Exuberance. Could I put some of my down payment kitty into something that tracks housing prices, so I can keep up with bubbles (too late for that, eh?) What about buying an ETF that is inversely correlated to the health of my job sector? Thanks for bringing this up.

  3. this is awesome piece of recommendation and reinforces my decision to come to this site everyday to find new money making posts – it is true and i don’t see gas prices going any lower than where its at but then who knows the future? instead of keeping money in banks which we know are just as dangerous these days (FDIC insurance is there but still there is enough skepticism in market right now) i would much rather get into similar hedging situations at least for the money i have to spend on higher future gas prices anyway.

  4. If the point is to hedge against the cost of gasoline in particular (and not the more general price of oil), one should consider UGA (http://finance.yahoo.com/q?s=uga). This ETF directly tracks the gasoline futures market. The disadvantage is that its thinly traded in comparison to the much more popular USO and OIL.

  5. Cool idea. It may be worth the small cost of hedging to protect against truly enormous price shocks, like would occur after a terrible hurricane or some geo-political happening in the middle east. I am probably not alone in that it was painful, but not crippling for me to adjust to the somewhat gradual increase from $2.50 to $4 over the course of a year. It was something else entirely when prices went from $2 to $3.50 almost overnight after Katrina.

  6. This kind of post is why I keep reading this blog. Thanks.

    Another factor to consider in judging the costs of hedging is the cost of buying and selling the ETFs. Depending on how much one’s gasoline bill is, trading fees could be an appreciable percentage of the value of one’s hedging.

  7. One problem might be that you’d have to declare the “gains” from your oil/gas hedge on your tax return even though you had to pay more for your gas during the month. Since it’s just gas for personal use, you can’t deduct that…but the IRS will surely see that you made money in the commodities market. Still, an interesting idea.

  8. I think you are forgetting the tax implications here. If you had the $1,000 appreciation in your oil stock/futures/etc and you sell to compensate you for the higher fuel prices – you are going to pay additional tax of up to $300 (roughly). It is not a hedge as you are not going to have and offsetting deduction for the higher fuel prices in the future. Not saying this is not still a decent option – but the potential cost is higher than you think.

  9. I just purchased shares of OIL last week. I commute about 40,000 miles a year and get a little over 28 mpg. Paying upwards of $600 a month just to get to work when gas was $4 made this decision (to hedge) a whole lot easier.

  10. Is the oil ETF comprised of shares of oil companies, or is it comprised of oil as a commodity? If it’s the former, I could think of occasions where the ETF would lost value even if oil prices. For example, if there were a major oil spill, the price of oil might not be much affected (it’s just one tanker), but the profitability of the oil company responsible could take a big hit because of its liability.

    My underlying question, then, is exactly what is the reason that the ETF correlates well with gas prices? Is it possible to buy a gasoline ETF that would be more likely to correlate, even in exceptional circumstances?

  11. I know what you are saying is correct, but I don’t think what you are saying really hedges you against prices.

    http://inflationdata.com/infla.....arison.htm

    There is a chart that tracks both gas and oil.

    1. they dont match exactly but they both do trend the same.

    2. Say you bought Oil in ’94 @ $15. Well you were hedged until ’96 when the value of oil started downward. If you sold at that point you would realize the hedged value. But if oil drops back down to $15 then your hedge has been worthless. you still had to pay the higher gas as it went up. And I think if you could time oil prices that well the cost of gas wouldn’t matter cause you would be a millionaire.

    3. With that said, I own an oil ETF and some oil companies.

    Not trying to sound rude or anything. I really love your blog.

  12. As a young person, I’d worry about saving for retirement and trying to maximize my yield.

    But this makes sense as you are approaching or starting retirement. It’s another expense that you can effectively lock-in a price so you don’t have to worry about “running out of money” in retirement.

  13. don’t the ETF’s track oil company stocks and not oil itself? So it wouldn’t be a true hedge but it’s the best we can do without being a commodities trader.

  14. simplesimon says:

    The timing of this post is a little funny because there is a thread on the Boglehead forums by EmergDoc that pretty much asks the exact same thing.

    I think a problem with this strategy is how do you know when to sell? If you own USO, for example, and oil prices rise after 6 months, do you sell for profits (that are also getting taxed as short term gains)? Or do you wait it out and after another six months prices fall back to what you bought in for? Then nothing has been accomplished.

  15. Yes, it’s a good time and you are thinking like a trader. Might want to reconsider your notions of trading the market.

    There will probably be a better time once this rally has ended and the markets head down again, I’m not sure of the exact time frame of that but could be a month or so.

    Just keep an eye on the dollar, it’s probably going to get weaker (and oil will go up), then stronger again, then sink for real.

    It’s not a bad time right now though if it’s a long term thing. There just might be a better time later.

    When to sell isn’t that hard really, once it’s doubled keep an eye out for when to get out, since speculators have to get out of the commodities by selling to someone who wants delivery, the long-term speculators (which is what you’ll be, since those ETFs are supported by futures contracts) can only drive the price up by double for any more than a short period (take a look at the chart, you’ll see that’s about where we’re at if you consider that 130-145 was a spike caused by short-term speculators, short-lived because a price more than double what is supported by people wanting delivery is can only exist for about the time it takes for a contract to expire).

    I’m sure I’m not explaining myself totally well, email me if any questions.

  16. Great idea. I don’t use much gas but I believe oil and gas prices will be much higher 4 years from now than they are today. I am not quite as sure 1 year from now but I would guess they will be higher. While there are some drawbacks (as commentors mention) this is a useful strategy to consider (as hedging or even as speculation).

  17. historical gas price data

    historical crude oil data

    The correlation is pretty good, although the price of crude has actually been a relatively higher multiple of the price of gas over the past couple of years.

    Taxes are good point, although you can also deduct capital losses. If you buy a year’s worth, then you can get the lower long-term capital gains rates. Those with low enough income have zero cap gains rate currently.

  18. Mickey Blue Eyes says:

    I compared USO, OIL, and DVY. The latter I currently own and is deep in the red. Over the past 12 months, their return (not including dividends) has been the same. USO and OIL went up and then came back down, whereas DVY just slowly went down.

    Should I use the Sharebuilder coupon code in another post to sell DVY and buy USO or OIL? Not until I read the Prospectuses, of course.

    I don’t want to get into a lot of watching and monitoring and active trading. I don’t have a very long attention span.

  19. Mickey Blue Eyes says:

    Correction: OIL is not available through Sharebuilder.

  20. There are sites that will do this for you. I use a site called petrofix.com.

    They pay you on the upside but you still get the benefit on the downside. They are kind of like a string of weekly puts. Definitely better than a gas card.

  21. Or you could simply hedge with the US Gasoline ETF – ticker UGA.

  22. DONT BUY OIL
    this is an ETN and has no assets.

    Exchange-traded notes (“ETNs”) are unsecured, unsubordinated debt obligations of the company that issues them and have no principal protection. Although an ETN’s performance is contractually tied to the market index it is designed to track, ETNs do not hold any assets. Therefore, unlike investors in exchange-traded funds (“ETFs”), which hold assets that could be liquidated in the event of a failure of the ETF issuer, ETN investors would only have an unsecured claim for payment against the ETN issuer in the event of issuer’s failure. Before investing, please carefully consider the credit worthiness of the ETN issuer and the ETNs investment objectives, risks, fees and charges.

  23. B-rad

    Can you please elaborate on your strategy that you mentioned..
    I completely understand options (you are talking about a credit spread)but I am missing something here regarding the 1000 cost…
    I think most readers here are smart and will benefit from your details..

    # B-rad Says:
    November 13th, 2008 at 7:34 am

    Not sure if you know much about options, but there are lots of strategies you could take part in to accomplish the same thing you are talking about.

    Right now Jan 2010 USO $50 Calls are trading for $1000.

    Or you could do a calendar spread to consistently reduce your cost basis + benefit from premium, for instance: purchase Jan 2010 USO $60 calls and sell Dec 08 $60 calls and take in $135. Each month you could sell additional calls and reduce your cost basis on the Jan 10 $60s to near nothing while still benefiting from oil rising.

    Of course if oil keeps falling we all have bigger problems to deal w/ since the market cannot move up w/out oil moving up. So would you rather have cheap gas or cheap net worth?

  24. If everyone were to take your advice wouldn’t we pretty much be pushing the price of crude oil higher as we are buying more contracts. Whereas if no one took any interest in oil, than the price of oil would fall. However, I still agree with your philosophy into buying these options on oil. I think no matter what happens in the next five years oil prices will continue to rise as the demand from India and China for oil. More countries are beginning to become more civilized and as they do they will consume more oil and the price will continue to shoot up. Why not take that money you are looking to hedge and invest in a more efficient fuel production?

  25. I like this idea but you aren’t fully hedging because you aren’t selling some of this stock every time you go to the pump. Since you go to the pump 1-4 times a month, but you only sell this stock once at the very end of the year, you aren’t truly matching the average buy price for all those purchases. What if you buy $1000 at $2, then gas rises and all year you are paying about $4 at the pump, but when a year is up and it comes time to sell the stock gas somehow drops back to $2?

  26. For me, hedging against gasoline prices is not worth the time of tracking another account. I honestly wouldn’t have even noticed the price of gas jump from 79 cents back in college to the peak of over $4 if it wasn’t all over the media. I know Americans complain all the time about high gas prices, but it’s not really a big deal if you’re earning in the top 10% of the nation (household AGI of around $109k). I think that’s very attainable for most married readers of this blog who have a college degree. The cost of a fillup inched up to maybe $50/week at the peak, which would’ve just meant eating out once less time per week. What’s the big deal?

  27. USO or USL? I just read this article and am now puzzled
    http://www.indexuniverse.com/b.....l?Itemid=3
    Here is an extract:
    The same company that offers USO offers a great little fund called the U.S. 12-Month Oil Fund (NYSE Arca: USL). Rather than simply holding the near-month futures contract, USL holds equal positions in each of the next 12 months’ worth of futures contracts. Spreading out its bets like that helps minimize contango, which tends to be worse in the near-month contract, and gives you more direct exposure to the spot price of crude.

  28. You all have good ideas, except all of you are missing one major point. To have an efficient hedge, you would have to sell shares of your ETF’s ETN’s, etc, everytime you went to the pump. This of course would incurr substantial commission/ trading costs. One cannot simply hold the shares of the ETF’s indefinitely. Nor can one hold the shares for an entire year when one pumps gas weekly. It’s possible that you can lose the opportunity to hedge completely. Many of you, I assume, plan on investing in funds that correlate closely with gasoline prices, and use the proceeds from the increases from that investment to offset your fuel costs. Yet, Consider the case where you pump gas weekly, yet never sell the ETF, or wait till the end of the year to sell your shares. In January, gas sells for $2.00 a gallon, and an ETF that tracks crude oil prices sells for $100/share. By June, gas sells for $3.00 a gallon and your ETF has appreciated to $110/share. However, you dont sell your shares of the ETF till December. By then, gas is back to $2.00/gallon, and your ETF has returned to $100/share. I hope now you all understand why you have to sell shares of your ETF’s as you pump for gas. Here, in this example, if you waited all year, you would have ended up paying $3.00/gallon for an extended period of time, yet would have never capitalized on the appreciation of your ETF funds. There are however natural hedges available soon. Fuelbank.com and mygallons.com are websites where one can prepurchase gasoline at todays prices. The sites simply send you a debit card that one can use at the pump. As gas is pumped, the gallons pumped are deducted from your online account. Another natural hedge is to physically buy gasoline, and store it. However, aside from the danger issues, gasoline goes stale. Finally, gasoline and crude oil do not correlate all that well, as we can see from the current deviation. A cited source claims that crude oil and gasoline are correlated with a value of .21. Hope this helps,

    Scott

  29. Its interesting to look at this in hindsight. From 11/14/2008 to 05/04/2012, UGA is up 90%, OIL is down -32% and USO is down -25%. The post said gas was near $2.15 back then and now it is near $3.50 or so, so UGA seems to be the smarter way to hedge. I dont know if any of these throw off dividends or cap gains so judging this just on price (via Google finance).

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