would havebeen $50. If the value of USO were to rise, you get to keep the $50as net profit. However, if it fell below the $73-per-share level, theshort 73 would risk exercise, while the long 74 could be closed.The short put could be rolled forward and down to avoid exercise.Like the long bull spread, the long bear spread offers limited riskalong with limited profit.It is also possible to create a bull spread employing puts, or abear spread with calls. The position of strike prices is simply reversed. Spreads are many and varied, and many also involve varying the expiration date, or both expiration and strike.A straddle is a different strategy altogether, in which you openboth a call and a put at the same strike price and expiration. Youcan open a straddle on either the long or the short side. An exampleof a long straddle on GSG (see Table 8-1) would involve openingtwo April 53 positions. The 53 call closed at 2.60 and the put closedat 3.50. So the cost of opening a long straddle would be $610. Thevalue of GSG at this point was $52.65 per share. So given the factthat this straddle cost $610 to open, if the stock were to move downto $46.55 or up to $58.75—a total range of 12.20 points—thisstraddle would not be profitable. You would need a larger movethan this ‘‘loss zone’’ move to produce a profit. A long straddle isappropriate when you expect a big move but you’re not sure of thedirection it will take.A short straddle involves selling both a call and a put of thesame expiration and strike. For example on GSG, you could sell an
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April 53 call for 2.60 and an April 53 put for 3.50, in which caseyou receive $610. Because you receive rather than pay, the previously indicated price range between $46.55 and $58.75 becomesa ‘‘profit zone’’ rather than a loss zone. As long as GSG remains inthis price range between January and the April expiration, the shortstraddle would be profitable. Even if one side or the other wereexercised, the option premium offsets the cost. (This calculationdoes not include transaction fees; however, those should be minimal if you use an online discount brokerage service.)The short straddle involves considerable risks if the underlyingsecurity is volatile. However, this risk can be minimized if you alsoown 100 shares of the underlying security, GSG in this case. Thenthe straddle becomes a combination of a covered call and an uncovered put. You start out with a $610 profit even if one side or theother is exercised. If the call is exercised, your 100 shares of GSGwould be called away; and as long as your original cost was lowerthan $53 per share, that would produce a capital gain. If the put isexercised, you would have another 100 shares put to you at $53per share, even though the price of GSG would be lower. So aslong as you consider $53 per share a good price, exercise of the putwould not be bad news. A few additional points to keep in mind:1. Either side can be rolled to avoid exercise, producing additionalincome. You can roll either the call or the put to avoid exercise.In volatile situations, you can also roll both, widening the gapbetween current market value and eventual exercise price. It isconceivable that you may avoid exercise indefinitely in thisstrategy.2. Exercise of the short put could lead to an additional profitableshort straddle with 200 shares. If and when the put is exercised,it doubles your position in the underlying security. Assumingyou want 200 shares rather than 100, this enables you to createadditional option income by writing a new short straddle. Nowyou can write two calls and two puts. The two calls would becovered and the two puts would be naked. Assuming you stilllike the price per share of the underlying security, this is oneway to recover the short option loss.
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3. Exercise of the put could produce a net loss, which could be offsetby writing subsequent covered calls. The net basis in the underlying security upon exercise would be the average of the originalbasis plus the exercised basis of the additional 100 shares. Aslong as calls are available with strike prices greater than the average basis in the underlying security, you can create additionalcovered call profits without writing a new short straddle. Thesenew covered calls can later be rolled forward again to avoid exercise.The use of options on futures indices and ETFs vastly expandsyour potential strategic approaches to this market. The futuresmarket appears cumbersome and involves many steps just to placeorders; a solution is to enter this market through pooled venuessuch as futures indices and ETFs. You really expand your potentialstrategies by picking ones allowing you to buy and sell options.Because these listed indices and ETFs trade just like stocks, but useone-point strike increments, they are extremely flexible.Option trading provides the best of both worlds: Access to fastmoving futures contracts, without the risk and high cost of tradingfutures positions directly.This concludes Part 2. Part 3 describes in detail each of themajor futures markets, one chapter for each sector.
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9
THE ENERGY MARKET
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his chapter provides an overview of the energy market, demandtrends, and a range of futures contracts (Brent crude oil, lightcrude, heating oil, natural gas, propane, and ethanol). Included aremarket explanations of the primary oil market as well as secondaryand alternative energy markets.Energy is the largest of all futures markets, and growing. Morefutures trading occurs in the major oil-related futures than in anyother. Energy prices affect all segments of society, and thus energyis a core economic force. It is also a political force, and as conflictor tensions arise in oil-producing nations, prices rise around theworld. Energy prices affect agricultural prices directly as transportation and production costs rise, so it is unlikely that the cycles inthe energy market will be downward in a big way at any time in thenear future.
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Basics of Energy MarketsBeyond the broad economic trends you can find with marketwide sources, you also will be able to locate useful informationfocused on specific futures. The energy market, for example, af147
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Classifications of Futures
fects virtually every other futures market. Because any shipmentfrom production to store requires truck, rail, air, and sea transportation, energy prices have risen in recent years to record-levelhighs. The cost of keeping businesses open, heated, and lit allrequire energy; all manufacturing and production efforts also demand energy use, and the more intense the activity, the moreenergy it requires.Crude oil experiences more trading volume than any other contracts, and it is used for 40% of worldwide energy consumption.Most economists agree that oil is the most important link in Western countries, and the lack of oil would cause recessions, as wasthe case following the oil embargo by OPEC in 1973. Given theindispensable nature of oil in so many aspects of the economy, it isclear why energy futures are so popular, and why they represent apromising commodity to trade. Even if you determine that alternative fuel sources are going to benefit from increasing prices, commodities such as ethanol and corn are affected directly as well.The United States imports more oil from Canada than fromanywhere else. As Figure 9-1 shows, the level of imports (based onthe number of barrels per day at the end of 2007) does not rely onthe Middle East as much as many people believe. In fact, 35% ofall imports come from Canada and Mexico.Production in Canada is likely to rise in the near future. According to data published by the Canadian Association of Petroleum Producers (CAPP, www.capp.ca), oil sands contain massivereserves, estimated at 175 billion barrels. As of the end of 2006, oilsand production represented 39% of Canada’s total oil production,or 1 million barrels per day. CAPP estimates that by 2020, that willgrow to 4 million barrels per day. The United States could extracta considerable number of reserves in the Arctic National WildlifeRefuge (ANWR). Although controversial, this area in northernAlaska may hold up to one-half of the total U.S. oil reserves. According to one study:ANWR, located in the northeast corner of Alaska entirely above theArctic Circle, comprises 19.6 million acres of the Brooks Range ofmountains and Arctic Coastal Plain abutting the Canadian Border
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FIGURE 9.1. PETROLEUM IMPORTS BY COUNTRY, 2007 (BARRELS PER DAY,IN THOUSANDS)
2,432 (21%)
Canada
1,550 (14%)
Mexico
1,456 (13%)
Saudi Arabia
1,357 (12%)
Venezuela
1,101 (10%)
Nigeria
699 (6%)
Algeria
Angola
523 (5%)
Iraq
494 (4%)
Russia
418 (3%)
335 (3%)
Virgin Islands
991 (9%)
Other
0
500
1,000
1,500
2,000
2,500
Source: www.eia.doe.gov, accessed December 28, 2007.
and the Arctic Ocean. According to the U.S. Geological Survey, theCoastal Plain of ANWR could contain up to 16 billion barrels of recoverable oil.That would make it the largest single oil reserve in NorthAmerica, containing almost half of the total U.S. known reserves of
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Classifications of Futures
oil. ANWR could, the Energy Information Administration reports, yieldmore than 1 million barrels of oil a day for more than thirty years.This is enough oil to replace approximately 30 years of oil importsfrom Saudi Arabia.1
Although the United States imports most of its oil (about 65%),most of that comes from friendly neighbors and allies. And contraryto many claims that the U.S. involvement in Iraq was devised to getthat country’s oil, only a very small percentage of imported oilcomes from that country. Production levels may be more importantfor futures prices than proven reserves, but all oil-producing countries have incentive to continue producing and selling oil to themajor consumers. Over 85 million barrels per day are used up, andthe two largest oil users are the United States and China.Crude oil prices have risen dramatically over the past few years.Between 1999 and 2007, the price of light crude oil rose fromabout $14 per barrel up to nearly $100. Figure 9-2 summarizesthis nine-year trend.Investing in the oil industry can be accomplished through individual company stocks, ETFs, or commodity indices. Major oilcompanies include:Company
Market Symbol
Cap 12/07
ExxonMobilPetroChinaPetroleoBrasileiroBPChevron
XOMPTRPBRBPCVX
$503B315241235197
Energy-based ETFs include the following, all trading on theAMEX:U.S. Oil Fund (USO)PowerShares DB Oil Fund (DBO)iShares S&P Global Energy Sector (IXC)Energy Select Sector SPDR (XLE)iShares Goldman Sachs Natural Resources (IGE)
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The Energy MarketFIGURE 9.2. LIGHT CRUDE OIL, PRICE PER BARREL, 1999 –2007
Source: Charts provided courtesy of TradingCharts.com: http//futures.tradingcharts.com; created with SuperCharts by Omega Research 䉷 1997.
Energy indices include:Name
Percent in energy
GSCIS&P Commodity IndexRICIReuters/Jeffries CRB
73.0%53.044.017.6
You can also trade commodities through a broker, in the following categories:Commodity Name and TypeBrent Crude OilEthanol
ExchangeIPE (International Petroleum Exchange)CBOT
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Classifications of Futures
Light Crude OilNYH RBOB GasolineGas-OilHeating OilNatural GasPropaneUnleaded Gas
NYMEXNYMEXIPENYMEXNYMEXNYMEXNYMEX
The importance and dominance of energy commodities trading—as both a necessity and as a defining economic force—is obvious based on rising prices per barrel, scarcity of domestic supplyversus demand, and anticipated higher demand in the future. Thisall makes energy futures a promising futures trade. In trading futures, two dominant factors should be kept in mind: supplies onhand in refineries and production capacity. Accidents or weatherrelated causes of shutdowns directly affect petroleum prices in theshort term (Hurricane Katrina, for example, after which 16 refineries were shut down, many for more than a full year).Crude oil is the most followed energy commodity, but otherimportant futures trades can also be made in unleaded gasoline,heating oil, and ethanol. In addition to the obvious domestic supplyand demand and refinery capacity as price factors, the geopoliticalclimate also affects oil prices. When Bhutto was assassinated inDecember 2007, oil prices approached $100, even though Pakistandoes not export oil. The regional tension, however, did have a direct effect. Political tension impacts oil even more than the oftencited ‘‘safe haven’’ of gold. Anticipation of future prices has asmuch to do with prices as OPEC policies or world tensions, andspeculation in energy futures only increases whenever the marketsworry about future supplies and prices.
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The Basics of Fossil FuelsBecause crude oil is a limited resource, it will eventually run out.Although today’s reserves seem high, usage has been rising in pastdecades so at some point the demand for crude oil will outpace theactual reserves. By that time, the world will need to have foundalternate sources of energy, or discovered ways to use oil moreefficiently. Oil itself exists in the ground, under the ocean, and in
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The Energy Market
sand deposits. Also known as ‘‘fossil fuel,’’ oil is believed to havebeen formed over millions of years from the remains of long-deadplants and animals. The organic layers that formed and were covered by sand over many millions of years eventually formed intocrude oil and natural gas. So in a sense, oil is a recycled product oforganic material. Crude oil consists of hydrocarbons, or molecularremains of hydrogen and carbon atoms.Various products are derived from distillation of crude oil. Eachchemical compound within oil has a separate boiling point. Crudeoil is distilled by burning off each product at its specific boilingpoint. Figure 9-3 shows this process.So crude oil is heated in a still column so that lighter products—for example, liquid petroleum gas (LPG), naphtha, andstraight-run gasoline—can be recovered at various temperatures.Middle-level products come next, including jet fuel, kerosene,home heating oil, and diesel fuel. Last, the heavy products are distilled, including residuum and residual fuel oils.F I G U R E 9 . 3 . C R U D E O I L D I S T I L L AT I O N : T H E F I R S T S T E P
ProductRecovered:Butane andLighter
Unit/UseSent to:GasProcessing
90–200°
Light StraightNaphtha
GasolineBlending
200–350°
Naphtha
CatalyticReforming
350–450°
Kerosene
HydroTreating
450–650°
Distillate
Dist. FuelBlending
650–1,000°
HeavyGas Oil
Fluid CatalyticCracking
1,000+°
Residuum
Coking
Temp. (°F):
CrudeOil
Distillation Column
<90°
Source: www.eia.doe.gov.
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Classifications of Futures
Oil is ‘‘mined’’ in various ways. Most people are familiar withthe most common, land-based or sea-based drilling. Rigs are constructed on the ground or on sea platforms, based on the locationof three key attributes. First the area must contain source rock thatindicates crude oil probably has formed. Second, that rock needsto be richly populated with organic material that has been converted to oil. Third, the oil must have migrated to an accumulationarea called reservoir rock. This is normally sandstone or limestone,porous enough to hold oil reserves. Assuming there is an adequatereserve of such oil on hand to justify the cost of exploration anddrilling, the extraction process begins.This requires introducing pressure adequate to force oil to thesurface. This includes a combination of natural pressure built upwithin the reservoir, which, when released, brings oil upward, andadditional pumping to bring up additional supplies. This continuesas long as production is high enough to cover costs and produceprofits. But once an oil well ceases to produce oil profitably, it iscapped and abandoned. It is interesting that as oil prices rise, someabandoned oil wells become viable once again. If oil profits can beachieved from once-abandoned wells, this secondary source canproduce additional recoverable reserves. Only a few decades ago,domestic oil reserves were viewed as quite limited, because thecost-benefit ratio simply wasn’t good enough. But with higher oilprices, recoverable reserves have grown.A relatively new, advanced method for crude oil extraction ishorizontal drilling. Under this method, a vertical drill begins theprocess, but it is then moved in an arc so that additional reservesare tapped via horizontal paths. This exposes additional reservoirrock and often expands the potential recoverability of a single wellor field. The horizontal drilling method is most effective whenworking in fractured conventional reserves or source rock as wellas to secondary efforts in previously abandoned wells.
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Shale Oil and Sand OilA promising development beyond traditional drilling is found inshale oil reserves. While extraction is more expensive than fromconventional drilling, reserves are enormous. The U.S.-based oilshale deposits are the largest in the world, located primarily in two
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The Energy Market
sites: the Devonian-Mississippian shale in the Appalachian basinand the Green River formation in Colorado, Utah, and Wyoming.These reserves are enormous, estimated between 1.5 and 2.6 trillion barrels.2Other worldwide shale reserves are substantial as well. Table9-1 summarizes the known reserves as of the end of 2005.Shale is rock-like and rich in kerogen, an organic material. Oilis extracted in two methods. First, the shale is mined and processedthrough heat and enrichment with hydrogen vaporization. The second involves heating shale while still in the ground until it fractures.This releases gases and liquids, which are then mined. Miningmethods yield different levels of oil, since the levels of kerogen content differ as well among fields.Oil sand deposits are also massive, and extraction methods beTABLE 9.1. IN-PLACE SHALE OIL RESERVES, WORLDWIDE
Deposit
Country
Green River FormationPhosphoria FormationEastern DevoniamHeath FormationOlenyok BasinCongo
U.S.U.S.U.S.U.S.RussiaDemocratic Republicof CongoBrazilItalyMoroccoRussia
Irati FormationSicilyTarfayaVolga BasinSt. Petersburg, Baltic OilShale BasinVychogodsk BasinWadi MagharDictyonema ShaleTimahditCollingwood ShaleItaly
RussiaRussiaJordanEstoniaMorocco1CanadaItaly
Millions ofBarrels
Millions ofTonnes
1,466,000250,000189,000180,000167,715
213,00035,77527,00025,57824,000
100,00080,00063,00042,14531,447
14,31011,4489,0156,4484,500
25,15719,58014,00912,3861,23612,30010,000
3,6002,8002,1491,9001,7191,7171,431
Source: World Energy Council (WEC), Survey of Energy Resources, 2007, table as of theend of 2005.
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Classifications of Futures
come more cost-effective over time. Most oil sand deposits are located in Venezuela and Canada. These deposits have been assignedseveral names, including tar sands, bituminous sands, and extraheavy oil. Canada supplies the United States with over 1 millionbarrels of oil per day, mined from tar sands. In the United States,the Utah tar sand area contains eight major deposits (the largest isthe Tar Sand Triangle) with estimated reserves of 32 billion barrels.It is complicated to mine sand oil because it is mixed with sandas well as water and clay, and has to be removed from its surroundings before it can be refined. This kind of crude oil is called bitumen, and two methods are commonly used in extraction. First isan on-site technique using hot water; about one-fifth of oil sandextraction occurs using this method. Second is a technique appliedwhen oil sands are too far beneath the surface to use the hot watertechnique. This method employs drilling down and then interjecting steam to reduce the viscosity of the bitumen. The bitumen isthen pumped to the surface via wells, and the sand is left behind.
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Crude Oil ProductionIn evaluating sources for ‘‘big oil,’’ two major groups have to bedistinguished. First is the Organization of Petroleum ExportingCountries (OPEC), founded in 1960 and consisting of 13 nations:five founding members (Saudi Arabia, Iran, Iraq, Kuwait, and Venezuela) and eight additional current members (Qatar, Indonesia,Libya, United Arab Emirates, Algeria, Nigeria, Gabon, and Angola). OPEC member nations depend on oil exports as their primary or sole means of national support and work together tocontrol production levels and prices. The official site of OPEC(www.opec.org) describes its purpose as coordination among itsmembers to ensure a reasonable rate of return on their investment,and to ensure that consuming countries have a stable supply of oil.While this is controversial and many disagree, one of the importantfactors in supporting oil prices is agreed-upon production levels foreach member country, as a contributor to world oil supplies.Non-OPEC production of crude oil is substantial. The formerSoviet Republic collectively is the largest non-OPEC oil producer.In 2005, OPEC produced 42% of all world oil consumed. Of non-
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157
OPEC production, the former Soviet Union (FSU) nations accounted for one-fourth of the total. While OPEC oil productiondominated until the mid-1970s, political unrest and rising oil pricesled to non-OPEC oil production growth; since that time, nonOPEC nations have produced most world oil. By 2005, these countries were producing nearly 50 million barrels per day, versusOPEC production under 35 million barrels per day.Government control of much of the production activity inOPEC countries determines not only production levels but cost.In those countries, government-run production dominates privatecompany efforts. For example, in Saudi Arabia, the Saudi familyowned company, Aramco Oil, produces three times more oil thanShell Oil; and oil reserves are approximately seven times higherthan Shell, Exxon, BP, and Chevron combined. So the governmentrun operation has far more influence on oil production and prices,even though non-OPEC production is greater on a worldwidebasis. The majority of non-OPEC producers are also net importersof oil, so reliance on world supplies including OPEC productiongives the OPEC cartel a lot of oil price influence and, as a result,affects oil futures as well.A long-standing question of when world oil reserves will runout also creates a permanent concern about oil prices. Estimates arecontinually updated, and, even today with dire predictions of globalwarming and expended oil supplies, the numbers are simply notknown by anyone with certainty. Not only have experts warned thatthe world is running out of oil (and has been for the past 100 years),but ‘‘peak production’’—that point where production is at its heightand the trend begins to turn downward—has also been continuallyupdated. As new data revise the previous estimate, the forecast iscontinually moved forward a few years. The following is a brief history of predictions about oil reserves and peak production:1914—Worldwide oil will last only one decade. (U.S. Bureauof Mines)1920—worldwide oil supplies total only 20 billion barrels.(U.S. Geological Survey)1922—The United States has only enough oil supply to last 20years. (U.S. Geological Survey)
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Classifications of Futures
1926—The world supply of oil totals only 4.5 billion barrels.(U.S. Federal Oil Conservation Board)1932—Only 10 billion barrels of oil remain. (U.S. Federal OilConservation Board)1944—Only 20 billion barrels of oil remain in the worldwidesupply. (U.S. Petroleum Administrator for War)1950—World oil reserves are down to 100 billion barrels.(American Petroleum Institute)1951—World oil supplies will last only another 13 years. (U.S.Department of the Interior)1972—Peak production will have been reached by the year2000. (Report to the UN Conference on Human Environment)1976—Oil supplies will peak at about the year 2000. (U.K.Department of Energy)1977—Consumption ‘‘could use up all of the proven reservesof oil in the entire world by the end of the next decade.’’(President Jimmy Carter)1977—The oil peak will occur in 1996. (Dr. M. King Hubbert)1979—The plateau of oil production will be reached ‘‘withinthe next 25 years.’’ (expert at Shell Oil)1981—Oil will ‘‘plateau around the turn of the century.’’ (TheWorld Bank)1995—The peak year will occur in 2005. (PetroconsultantsC. J. Campbell and J. H. Laherrère, The World’s Supply ofOil, 1930–2050)1997—The peak will occur in 2010 (L. F. Ivanhoe, ‘‘UpdatedHubbert Curves Analyze World Oil Supply,’’ World Oil217, No. 11 [November 1996]: 91–94) or 2020 (J. D. Edwards, ‘‘Crude Oil and Alternative Energy ProductionForecasts of the Twenty-First Century: The End of the Hydrocarbon Era,’’ AAPG Bulletin 81 [1997]: 1292–1305)1998—Oil will peak in 2014. (International Energy Agency)1999—The USGS revised prediction, as well as author C. J.Campbell, chose 2010 as the peak year for oil. (U.S. Geo-
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logical Survey and author C. J. Campbell, ‘‘Oil Reservesand Depletion,’’ PESGB Newsletter, Petroleum ExplorationSociety of Great Britain, (March 1999): pp. 87–90.)2001—Peak production will occur in 2003. (K. S. Deffeyes,Hubbert’s Peak Princeton University Press, 2001.)
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Hubbert’s Peak TheoryTo appreciate how supply and demand trends work, you need tofirst know the nature of the commodity involved. Agricultural commodities are renewable as long as farmers are able to plant andharvest new crops each year; the same argument applies to lumber.But oil is a limited resource, so for many years predictions havebeen made (see the previous section) about an impending depletionof the resource. The best-known theory is called Hubbert’s Peak.M. King Hubbert, a geologist who worked at Shell Oil, predicted a worldwide point at which oil production would reach itspeak and then begin to decline. This forecasting point is meant tosignal when supplies actually start running out. Hubbard presentedhis ideas in a presentation to the American Petroleum Institute in1956.3 Hubbert argued that the rate of oil production would eventually enter a terminal decline, in a period he identified between1965 and 1970. In 1976, Hubbert revised his estimate by 10 years,citing a flattening of the global production volume by OPEC.The idea that the world will eventually run out of oil—assuming no changes in production levels, efficiency, or alternativefuel sources—is of course of great concern to any nation consuming imported oil. However, no one really understands the extent ofactual reserves, and over the history of the auto and airplane age(only about 100 years old), reserve levels have been updated asever-higher reserves have been discovered.However, even though Hubbert’s original mathematical modelsshows U.S. oil production peaking around 1971, this does notprove that the theory is either correct or accurate. As a theory developed and based on U.S. oil production, it cannot be applied withaccuracy to worldwide reserves and production trends. Since Hubbert’s original publication of his theory, numerous new methods ofdrilling and sources of oil (for example, shale and sand oil) have
160
Classifications of Futures
evolved. Many oil wells formerly capped may be reopened as higheroil prices make extraction economically viable. New discoveriesconstantly throw estimates off course.It might be true that the world will eventually run out of fossilfuels, especially if consumption continues to rise. However, production levels are not isolated factors that can be based on a 1956model, and both economic and political developments affect how,when, and where oil is going to be produced in the future. Hubbertrelied on known and proven reserves in 1956, when he announcedhis ideas. However, among OPEC nations alone, proven reservelevels have been doubled between 1980 and 2006, according to theBP Statistical Review of World Energy in 2006 (www.bp.com). Thisknown change in reserve levels occurred during a period when oilconsumption was also on the rise, which throws Hubbert’s estimates into disarray—even though his theories are often cited todayas ‘‘proof’’ that world oil supplies are now dwindling.For oil futures traders, never-ending fear about running out ofoil must certainly keep oil prices on the rise. The long-term prospects for oil futures prices are upward and have been for sometime. However, on a realistic level the chances of the world runningout of energy any time in the immediate future are remote. Thedevelopment of alternative fuel sources and more efficient automobiles, to name only two obvious developing trends, will furtherthrow Hubbert’s estimates off. The trend of predictions between1914 and 2001 are likely to be more or less duplicated from 2001