Profit from oil – whether it rises or falls

Oil cartel Opec had its worst-ever meeting last week. At least, that's how the Saudi Arabian oil minister described it. The Saudis had failed to convince the likes of Iran and Venezuela to increase production quotas. On the one hand, the Saudis and other oil regimes need prices to remain above $80 a barrel to balance their budgets, particularly as many are spending more on public services to keep their populations happy amid the unrest in the Middle East. But the Saudis also believe that if oil stays at current prices around $100 as measured by the US benchmark, West Texas Intermediate Crude (WTI) the danger is that the global economy will fall into a slump. That would hammer oil prices as demand dropped off.

This dilemma also sums up the risks to investors looking to bet on the oil market. At current levels, oil is historically high, but it's still well off the record $147 seen in 2008. While a weaker global economy would hit prices, any further turmoil in the Middle East could send them higher. The good news is, there are a couple of trades you can use to profit from the oil market, regardless of whether prices rise or fall.

Why not spread-bet a spread?

The trades involve spread-betting. Spread-betting is risky you can lose more than your initial stake so do make sure you understand what you're doing (see www.moneyweek.com/SB for more).

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It's also important to understand how ticks, pips and bet sizes work in the specific market you're trading. Usually, if you are betting on Brent Crude, for example, you bet a number of pounds per $0.01 movement in the price. So if you bet at £10 per "point" or "tick" and the price moves by $0.05, you have made or lost £50.

So what should you bet on? The two big oil contracts are Brent Crude and the slightly lighter WTI. Although both are quoted in US dollars, they are not the same product.

Developments that affect US supply such as the recent resumption of shipments via the key TransCanada pipeline have a much greater impact on WTI. That's reflected in their prices. While Brent trades at around $118 a barrel, WTI trades nearer $100. And here's where the first opportunity arises.

There are many theories that try to explain the current size of the gap from tight supplies in Europe to a glut in America but as Izabella Kaminska puts it on FT Alphaville, "most analysts remain stupefied as to the reasons behind it". However, one thing is for sure the spread' between the two benchmarks is near-record levels of around $20. When this sort of anomaly happens, you would normally expect the market to revert to the mean' over time.

So one option would be to do a pairs trade', betting that the spread would narrow. To do this, you simultaneously short Brent Crude and buy WTI. What happens to the price of each doesn't matter what you care about is the gap between the two. If it narrows, you would then reverse both trades to take a profit. If it widens further, you would lose money.

Play natural gas against oil

Another option is to trade the oil price against natural gas. As the oil price surges, you would expect gas prices to rise too. That's because gas is a less expensive substitute so, to an extent, users can switch from one to another when one becomes too expensive. And indeed, according to Willem Weytjens on Marketoracle.co.uk, the correlation (see below) between oil and natural gas between 1986 and 2009 is around 88%. However, that correlation has weakened recently (taken up to 2011 it drops to 80% still pretty significant). That's due in part to some big new sources of gas supply coming on tap in the States, while demand has remained steady.

So where are we now? Well, says Weytjens, the long-term average ratio of oil to natural gas prices is about eight. Currently the ratio is around 20. That suggests that "oil is too expensive relative to natural gas (if history is any guide)". If that's true a pairs trader would look to short oil while buying natural gas as a bet on the spread narrowing. Again, a nice bonus is that this trade will make money whether or not the price of both assets rises or falls what you are actually betting on is the spread between natural gas and oil prices narrowing.

What is correlation?

This is a snapshot of the extent to which two asset prices track each other. The result is given as either a number between -1 and +1 or a percentage. If two assets move up and down in lock step, the correlation is 1, or 100%. If they move exactly in opposite directions (so as one rises 10%, the other falls 10%) the correlation coefficient is -1. Readings of either +1 or -1 are rare in practice. A zero reading means two asset prices show little correlation. Leaving aside the slightly fiddly maths, the concept sounds simple enough. However, firm conclusions need to be drawn with care. For example, I may observe that sales of BBQs and sales of tennis rackets are correlated. But both may be spuriously correlated by another factor, such as the weather. If so, drawing conclusions about how one product will behave based on demand for, or the price of, the other is dangerous.

This article was originally published in MoneyWeek magazine issue number 542 on 17 June 2011, and was available exclusively to magazine subscribers. To read all

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